Allowance for Doubtful Accounts

What is Allowance for Doubtful Accounts?

Definition: Allowance for doubtful accounts, also called the allowance for uncollectible accounts, is a contra asset account that records an estimate of the accounts receivable that will not be collected. In other words, it’s an account used to discount the accounts receivablea ccount and keep track of the customers who will probably not pay their current balances.

The allowance for doubtful accounts is a reduction of the total amount of accounts receivable appearing on a company’s balance sheet, and is listed as a deduction immediately below the accounts receivable line item. This deduction is classified as a contra asset account. The allowance represents management’s best estimate of the amount of accounts receivable that will not be paid by customers. It does not necessarily reflect subsequent actual experience, which could differ markedly from expectations. If actual experience differs, then management adjusts its estimation methodology to bring the reserve more into alignment with actual results.

What Does Allowance For Doubtful Accounts Mean?

What is the definition of allowance for doubtful accounts? The allowance method reduces the carrying value or realizable value of the receivables account on the balance sheet. In other words, this method reports the accounts receivable balance at estimated amount of cash that is expected to be collected. As opposed to the direct write off method, the allowance-method removes receivables only after specific accounts have been identified as uncollectible.

The allowance is established by recognizing bad debt expense on the income statement in the same period as the associated sale is reported. Only entities that extend credit to their customers use an allowance for doubtful accounts. Regardless of company policies and procedures for credit collections, the risk of the failure to receive payment is always present in a transaction utilizing credit. Thus, a company is required to realize this risk through the establishment of the allowance account and offsetting bad debt expense. In accordance with the matching principle of accounting, this ensures that expenses related to the sale are recorded in the same accounting period as the revenue is earned.

Allowance for Doubtful Accounts
Allowance for Doubtful Accounts

Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity does not know for certain which exact receivables will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must still be established in the same accounting period as the sale but can be based on an anticipated and estimated figure. The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account. Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected.

Example

The allowance-method works by first estimating bad debt for the period. Management carefully examines an accounts receivable aging schedule to estimate what amount of each account will be uncollectable. Then a journal entry is made to record the uncollectable balance by debiting bad debt expense and crediting the allowance for bad debt account.

Notice that the accounts receivable account isn’t credited. Instead the allowance account is used to reduce the receivables indirectly. This means that the customer’s balance is still recorded in the receivables account.

Most balance sheets present these two accounts separately by showing the gross AR balance and subtracting the allowances to arrive at the outstanding AR balance. This amount represents the amount of cash management actually expects to collect from its customers. This presentation isn’t required, however. Some financial statements display the net AR balance and report the allowance in note format.

If a specific account has been deemed to be completely uncollectable, for instance a customer declares bankruptcy, the company would record a journal entry to remove the account from the AR account and the allowances account by debiting allowance and crediting accounts receivable.

Estimation Techniques for the Allowance for Doubtful Accounts

There are several possible ways to estimate the allowance for doubtful accounts, which are:

  • Risk classification. Assign a risk score to each customer, and assume a higher risk of default for those having a higher risk score.
  • Historical percentage. If a certain percentage of accounts receivable became bad debts in the past, then use the same percentage in the future. This method works best for large numbers of small account balances.
  • Pareto analysis. Review the largest accounts receivable that make up 80% of the total receivable balance, and estimate which specific customers are most likely to default. Then use the preceding historical percentage method for the remaining smaller accounts. This method works best if there are a small number of large account balances.

You can also evaluate the reasonableness of an allowance for doubtful accounts by comparing it to the total amount of seriously overdue accounts receivable, which are presumably not going to be collected. If the allowance is less than the amount of these overdue receivables, the allowance is probably insufficient.

You should review the balance in the allowance for doubtful accounts as part of the month-end closing process, to ensure that the balance is reasonable in comparison to the latest bad debt forecast. For companies having minimal bad debt activity, a quarterly update may be sufficient.

Companies have been known to fraudulently alter their financial results by manipulating the size of this allowance. Auditors look for this issue by comparing the size of the allowance to gross sales over a period of time, to see if there are any major changes in the proportion.

Is Allowance for Doubtful Accounts an Asset?

Doubtful accounts are an asset. The amount is reflected on a company’s balance sheet as “Allowance For Doubtful Accounts”, in the assets section, directly below the “Accounts Receivable” line item.

Doubtful accounts are considered to be a contra account, meaning an account that reflects a zero or credit balance. In other words, if an amount is added to the “Allowance for Doubtful Accounts” line item, that amount is always a deduction.

Recording the amount here allows the management of a company to immediately see the extent of the expected bad debt, and how much it is offsetting the company’s account receivables.

What Is the Journal Entry for Allowance for Doubtful Accounts?

Let’s use an example to show a journal entry for allowance for doubtful accounts.

Let’s say a company has calculated that $10,000 of its sales revenue are doubtful. This amount needs to be recorded in the company’s general ledger as both a debit and credit. It can be done as follows:

  • Debit the expense as “Bad Debt Expense” account.
  • Credit the allowance for “Doubtful Accounts”.

The doubtful accounts will be reflected on the company’s next balance sheet, as a separate line. It will offset the accounts receivable by $10,000.

The remaining amount from the bad debt expense account (the portion of the $10,000 that is never paid) will show up on a company’s income statement.

Does Allowance for Doubtful Accounts Get Closed?

Allowance for doubtful accounts do not get closed, in fact the balances carry forward to the next year. They are permanent accounts, like most accounts on a company’s balance sheet.

Bad debt expenses, reflected on a company’s income statement, are closed and reset.

Let’s give an example.

Peter’s Pool Company, based in Tampa, Florida, has estimated the balance allowance for doubtful accounts to be 14k. For the purposes of this example, let’s assume the 14k is 100% accurate and that none of that amount gets collected from the company’s clients.

Here’s what happens:

  • On the balance sheet, the 14k is listed in assets as a deduction, directly below the accounts receivable figure. At end of the year, that 14k figure stays, and new allowances are added.
  • On the income statement, the 14k is listed as a bad debt expense. This amount will affect the company’s net income. However, now that it has been accounted for, the 14k will be eliminated with the next income statement, and reset to $0.00.

Direct Write Off Method vs Allowance for Doubtful Accounts

Some companies prefer direct write off method than making an allowance for doubtful accounts for accounting for bad debts. Under this method, the companies decide that they do not have any option of recovering the amount. This usually happens when none of the recovery attempts work.

Writing off the debt means the companies debiting the bad debt expenses and crediting the accounts receivables account. The IRS guidelines prefer the write-off method, but it does not conform to the GAAP (Generally Accepted Accounting Principles).

Generally, companies prefer this method for small accounts that do not impact financial records significantly. Also, this method is simple and helps with the tax as well. One drawback of this method is that the balance sheet does not give an exact representation of the company’s account receivable. Moreover, it can also encourage expense manipulation as a company records expense and revenue in different periods.

Allowance for doubtful debt, on the other hand, gives an accurate matching of the financial records as it adheres to the matching principle. Unlike the direct write off method, the balance sheet here provides an accurate record of the expenses. Under this, the companies don’t immediately write-off the accounts, rather, it first estimates the bad debt amount.

One possible drawback of this method is that management might make a wrong estimation of the allowance. This could misstate the net income. To overcome this, management must review the allowance for doubtful accounts monthly to ensure that it is not over or understated.

Summary Definition

Define Allowance For Doubtful Accounts: Allowance for uncollectibles means a method for identifying bad receivables and removing bad debt from the books.

  • The allowance for doubtful accounts is a contra-asset account that records the amount of receivables expected to be uncollectible.
  • The allowance is established in the same accounting period as the original sale, with an offset to bad debt expense.
  • The percentage of sales method and the accounts receivable aging method are the two common ways to estimate uncollectible accounts.

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