Example

Bike LTD sells a mountain bike to XYZ for $115 on credit. Sales tax is 15%.

As the sale of $115 includes an element of sales tax, we need to first separate tax from the gross amount. Sales tax on the transaction may be calculated as follows:

Sales Tax: 115 x 15/115 = $15

Deducting sales tax from the gross sale revenue, we may now arrive at the tax exclusive sale value:

Tax Exclusive Sales: 115 - 15 = $100

This is the amount to be recognized as sales in the income statement. The accounting entry will therefore be as follows:

		$	$
Debit	XYZ (Receivable)	115
Credit	Sales		100
Credit	Sales Tax (Payable)		15

Upon receipt of the amount receivable from XYZ, following double entry will be made:

		$	$
Debit	Cash	115
Credit	XYZ (Receivable)		115

The sales tax payable of $15 will stand until it is paid to the tax authorities.

Allowance Method for Reporting Credit Losses

Accounts receivable are reported as a current asset on a company's balance sheet. Since current assets by definition are expected to turn to cash within one year (or within the operating cycle, whichever is longer), a company's balance sheet could overstate its accounts receivable (and therefore its working capital and stockholders' equity) if any part of its accounts receivable is not collectible.

To guard against overstatement, a company will estimate how much of its accounts receivable will never be collected. This estimate is reported in a balance sheet contra asset account called Allowance for Doubtful Accounts. (Some companies call this account Provision for Doubtful Accounts or Allowance for Uncollectible Accounts.) Any increases to Allowance for Doubtful Accounts are also recorded in the income statement account Bad Debts Expense (or Uncollectible Accounts Expense).

This method of anticipating the uncollectible amount of receivables and recording it in the Allowance for Doubtful Accounts is known as the allowance method. (If a company does not use an allowance account, it is following the direct write-off method)

Writing Off an Account under the Allowance Method

Under the allowance method, if a specific customer's accounts receivable is identified as uncollectible, it is written off by removing the amount from Accounts Receivable. The entry to write off a bad account affects only balance sheet accounts: a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable. No expense or loss is reported on the income statement because this write-off is "covered" under the earlier adjusting entries for estimated bad debts expense.

Bad Debts Expense as a Percent of Sales

Another way sellers apply the allowance method of recording bad debts expense is by using the percentage of credit sales approach. This approach automatically expenses a percentage of its credit sales based on past history.