2. Explanation of percentage-of-sales approach

Percentage-of-sales approach (income statement approach) states that the amount of bad debt expense to be recognized by a company is calculated as a percentage of credit sales generated during the current accounting period. This approach does not consider the balance in the allowance for doubtful accounts because such balance is not used in the calculation of bad debt expense.

Percentage-of-sales approach is based on sales revenues; which is why it is also called an income statement approach.

Let’s look at an example. Assume that Company ABC uses past experience to estimate that 3% of all credit sales result in uncollectible amounts (i.e., bad debt expense). During 20X2 the company had $200,000 credit sales. The company will book the following journal entry:

The $6,000 was calculated as follows:

$3,000 = $200,000 x 3%

It is irrelevant in this case what the balance was in the allowance for doubtful accounts before the adjustment because the bad debt expense is determined based on credit sales.

At any time the company has to write off bad debts, it will do so by debiting the allowance for doubtful accounts and crediting accounts receivable. For example, if in 20X3 the company learnt that $1,500 became uncollectible, the following journal entry would be made:

As you can see, when bad debts are written off (i.e., in 20X3 in our example) there is no impact on the income statement. That is because the bad debt expense was recognized when the company recorded the estimated uncollectable amount in the period of respective sales recognition. So, bad debt expenses are only recorded when the company posts the estimates of uncollectable balances due from customers, but not when bad debts are actually written off.  This approach fully satisfies the matching principle because revenues and related bad debt expenses are recorded in the same period.

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