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Percentage of Sales Method for Estimating Bad Debt Expense

Lesson
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One of the most common questions when purchasing an item is, "Cash or credit?"

Paying with cash makes everything easy, from an accounting perspective, but customers love to use credit.

There's a problem when credit is used though. Not everyone will wind up paying, either because they're broke, dishonest, or a disagreement has taken place.

Companies need to account for this fact with an estimate.

We call this estimate the allowance for doubtful accounts.

The simplest means of creating an estimate is to simply assume that a certain percentage of credit sales will fail. The percentage will vary and is often based on criteria like historic failures to pay for the company and the industry as a whole.

There are three sets of journal entries that are involved in the percentage-of-sales method for estimating bad debt expense:

  1. Estimate the bad debt expense
  2. Write-off bad debt
  3. Recover bad debt
Question
Ultra Biz, the infamous cable designer, expects 7% of customers to not pay for their purchases made on credit. The company is rather concerned, as it currently has $302,000.00 worth of credit sales on its books.
What are the journal entries to record the initial estimation of credit sales that won't be paid?
Answer
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👉 Answer:

  • Bad debt expense     $21,140.00    
         Allowance for doubtful accounts     $21,140.00    

👩‍🎓 Here's how we arrived at the answer:

  1. Let's think about the bad debt expense formula
    BAD DEBT EXPENSE = CREDIT SALES * ESTIMATE OF PERCENT NOT PAYING
  2. Now let's plug in the numbers
    $21,140.00 = $302,000.00 * 7%
  3. Next, let's remember the formula for allowance for doubtful accounts
    ALLOWANCE FOR DOUBTFUL ACCOUNTS = CREDIT SALES * ESTIMATE OF PERCENT NOT PAYING
  4. And let's apply the numbers
    $21,140.00 = $302,000.00 * 7%
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