This method more closely resembles the matching principle because the bad debt expense is matched against the sales that were made to incur it. There are two different ways of estimating this expense. The first is as a percentage of credit sales and the second is a percentage of receivables.
Companies use the aging report to make a dollar estimate of how much they will lose in unpaid account balances. At that time we have no way to know exactly which customers won't pay. But by tracking its business history a company can estimate a dollar amount that they believe is reasonable. .
When the allowance account is established, an expense account is also debited. That account is called Bad Debt Expense. So the loss due to bad debts is recognized as a normal business expense on the Income Statement. .
Periodically, and no less than once a year, a company must review it's accounts receivable and identify any customers who have not paid their bill for a very long time, generally over 90 days. Information is gathered about these customers, and attempts at collection should be made. However, the customer may be out of business, bankrupt, etc. and it is unlikely these customers will pay the company. .
When this happens, the debt is no good and should be removed from the books. An entry is made to both accounts receivable and the allowance account, reducing the balance in both accounts. Potentially collectible accounts should be pursued and only legitimately uncollectible accounts should be written off. .
The allowance method is acceptable for accounting, and correct under GAAP. However, no allowance expense is permitted for tax returns. Only accounts actually written off can be expensed on a tax return, and then only in the year the account is deemed uncollectible.
After the company deems the account as uncollectible it may choose to engage a collection agency to further pursue collection. Commercial debt collection agencies are hired collect the claim in full as quickly as possible with the least cost to the company.
