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: