Problem:
On January 1, 2003, a company's accounts receivable balance was $8,900 and the allowance for doubtful debts was $600. This information came from the December, 31 2002 balance sheet. During 2003, The company reported $77,000 of credit sales. During 2003, $400 worth of receivables were written off as uncollectible. Cash collections of receivables were $69,000 for the year. The company estimates that 3% of the year-end accounts receivable will be uncollectible. What is the bad debt expense for the year ending December 31, 2003 ?
---------
To calculate the year ending Accounts Receivable balance, you will need to add credit sales for the year and subtract any write offs and collections. You will use this new, year-ending balance to determine how much will be uncollectible. The percentage given in the problem is 3% of this balance.
However, you will not necessarily charge off the entire 3% to Bad Debt Expense. When using the allowance method, you just need to bring the balance of the Allowance account up to that 3%. So, to do this, you need to determine the updated balance of the Allowance account before you will know how much is additional Bad Debt Expense.
Therefore, you start with the beginning-year Allowance account balance and update (reduce) that balance for changes (write-offs). That will give you the updated balance. Then, you determine how much of an adjustment is needed to bring the Allowance balance to the 3% you calculated. The amount needed to do that is the amount you will charge to Bad Debt Expense.
The reason you don't charge the entire 3% to Bad Debt Expense is each year this is an estimate, and estimates are not usually exactly right on the money. So each year you just want to keep the Allowance balance at the 3% level. Therefore, you only adjust (charge to Bad Debt Expense) whatever it takes to bring the Allowance balance to 3% of the current Accounts Receivable balance.