An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible. Nevertheless, the actual payment behavior of customers may vary significantly from these estimates.
Key Takeaways
- The allowance for doubtful accounts is a contra account that records the percentage of receivables expected to be uncollectible. Companies can specifically trace accounts when necessary.
- It is established within the same accounting period as the original sale, with a corresponding entry to bad debt expense.
- The two most common methods to estimate uncollectible accounts are the percentage of sales method and the accounts receivable aging method.
- Companies may also use specific identification, historical data, or risk assessment to determine the estimate.
- The objective of the allowance is to employ the matching principle between revenues and expenses while also reporting the net amount of assets using the conservatism principle.
Understanding the Allowance for Doubtful Accounts
No matter what a company’s credit policies and collection processes are, the risk of non-payment is always inherent in transactions made using credit. Thus, a company must acknowledge this risk by establishing an allowance for doubtful accounts and recognizing an offsetting bad debt expense. Following the matching principle of accounting ensures expenses related to sales are recorded in the same accounting period that the revenue is earned. This practice enables more accurate estimation of the real value of accounts receivable.
As the allowance for doubtful accounts is created within the same accounting period as the original sale, the entity does not know for sure which specific receivables will be collected and which will be defaulted. Hence, generally accepted accounting principles (GAAP) mandate that the allowance be created within the same accounting period as the sale, but it can be based on estimated figures. The allowance can accumulate across periods and may be adjusted as necessary based on account balances.
Companies that do not issue credit sales, require collateral, or only work with high-credit customers may not need to estimate uncollectibility and may not need an allowance for doubtful accounts.
Methods to Estimate the Allowance for Doubtful Accounts
Two primary methods are commonly used to estimate the uncollectible accounts.
Percentage of Sales Method
This method applies a fixed percentage to the total dollar amount of sales for the period. For example, based on historical data, a company might expect 3% of net sales to be uncollectible. If the net sales for a period amount to $100,000, the company will establish an allowance for doubtful accounts of $3,000 while simultaneously reporting a $3,000 bad debt expense.
If the subsequent accounting period results in net sales of $80,000, an additional $2,400 will be recorded in both the allowance for doubtful accounts and bad debt expense, bringing the total allowance to $5,400.
Accounts Receivable Aging Method
This method groups all outstanding accounts receivable by age and applies specific percentages to each group. The total of these group results constitutes the estimated uncollectible amount.
For instance, a company has $70,000 of accounts receivable less than 30 days old and $30,000 more than 30 days old. Based on past experience, 1% of accounts receivable less than 30 days old and 4% of accounts receivable over 30 days old will be uncollectible.
Therefore, the company will report an allowance of $1,900 ((70,000 1%) + (30,000 4%)). If the following period requires an estimated allowance of $2,500, the adjusting entry would be $600 ($2,500 - $1,900).
Advanced Methods to Estimate Allowance for Doubtful Accounts
Risk Classification Method
Companies may also classify different types of debt or vendors using risk classifications. For instance, a start-up customer might be high risk compared to a long-tenured, established customer. The percentage assigned to each classification then informs the total allowance for doubtful accounts.
Historical Percentage Method
If a company consistently tracks bad debt, it can use the historical percentage if deemed applicable to current debt situations. For instance, a company with a 10-year average of 2.4% bad debt could apply this figure to its current accounts receivable, subject to consideration of any outliers.
Pareto Analysis Method
Pareto analysis often shows that 80% of accounts receivable are concentrated in a small number of accounts (20%). This 80/20 corruption generalization is prevalent across business functions. Weighing calculative estimates preferentially by high or low concern wise weights only fitting those extensively maestro accounting computations ground gold questionnaires better.
Specific Identification Method
Consider a company with 100 clients, 11 of which are assumed uncollectable. The company can aggregate these 11 customers’ account balances to set the allowance. Management discloses the method in financial statement notes.
How to Account for Allowance for Doubtful Accounts?
Establishing the Allowance
First, the allowance must be established. In this example, a company predicts $500,000 in uncollected accounts receivable.
DR Bad Debt Expense $500,000
CR Allowance for Doubtful Accounts $500,000
Note that this expense hits when creating or adjusting the allowance, offsetting uncollectibles as actual figures obtained establish grounding evidences accordingly amid seasonal continuity across metrics customers wise balancing accesses granted. Get predictable professionally delving wise adjusted methodology catering question batches refining précises steps.
**Related Terms:** Contra Account, Balance Sheet, Accounts Receivable, Credit, Bankruptcy.
### References
## Get ready to put your knowledge to the test with this intriguing quiz!
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## What is an Allowance for Doubtful Accounts?
- [ ] An account used to record all revenue
- [x] A contra-asset account reducing total accounts receivable
- [ ] An account used to record liabilities
- [ ] A permanent equity account
## What does the Allowance for Doubtful Accounts represent?
- [ ] Cash reserves to cover all unknown expenses
- [x] An estimate of accounts receivable that are unlikely to be collected
- [ ] Unrecorded assets
- [ ] Fixed assets' depreciation
## Why is the Allowance for Doubtful Accounts important in financial accounting?
- [x] It aligns reported accounts receivable with expected future cash flows
- [ ] It inflates the company's net income
- [ ] It reduces tax liabilities significantly
- [ ] It represents actual cash set aside by the company
## Which method can be used to calculate the Allowance for Doubtful Accounts?
- [ ] Straight-line method
- [ ] Last-in, First-out (LIFO) method
- [x] Percentage of Sales/Receivables method
- [ ] Net present value method
## Under which principle is the Allowance for Doubtful Accounts created?
- [ ] Revenue Recognition Principle
- [ ] Cost Principle
- [x] Matching Principle
- [ ] Conservatism Principle
## Which financial statement includes the Allowance for Doubtful Accounts?
- [ ] Income Statement
- [ ] Statement of Cash Flows
- [ ] Retained Earnings Statement
- [x] Balance Sheet
## How does the creation of an Allowance for Doubtful Accounts affect the Accounts Receivable account?
- [ ] It increases the balance of Accounts Receivable
- [x] It reduces the net balance of Accounts Receivable
- [ ] It has no effect on Accounts Receivable
- [ ] It converts Accounts Receivable to a liability
## What entry is typically made when increasing the Allowance for Doubtful Accounts?
- [x] Debit Bad Debt Expense, Credit Allowance for Doubtful Accounts
- [ ] Debit Accounts Receivable, Credit Allowance for Doubtful Accounts
- [ ] Debit Allowance for Doubtful Accounts, Credit Accounts Receivable
- [ ] Debit Revenue, Credit Bad Debt Expense
## When should the balance of the Allowance for Doubtful Accounts be reviewed and adjusted?
- [ ] Annually
- [ ] Monthly
- [ ] Quarterly
- [x] Regularly, based on the company's policy (e.g., every reporting period)
## Which of the following adjusts when a specific account is deemed uncollectible and written off?
- [ ] Revenue
- [ ] Expenses
- [x] Both Accounts Receivable and Allowance for Doubtful Accounts
- [ ] Cash on Hand
