Allowance for Doubtful Accounts: Methods of Accounting for

Suppose a company generated $1 million of credit sales in Year 1 but projects that 5% of those sales are very likely to be uncollectible based on historical experience. Most balance sheets report them separately by showing the gross A/R balance and then subtracting the allowance for doubtful accounts balance, resulting in the “Accounts Receivable, net” line item. Note that the accounts receivable (A/R) account is NOT credited, but rather the allowance account for doubtful accounts, which indirectly reduces A/R. The allowance for doubtful accounts is then used to approximate the percentage of “uncollectible” accounts receivable (A/R).

• This is where a company will calculate the allowance for doubtful accounts based on defaults in the past.
• Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent.
• Later, if a customer fails to pay their account balance and the company deems the account uncollectible, they would record another journal entry to write off the bad debt.
• Let’s assume that a review of the accounts receivables indicates that approximately $600 of the receivables will not be collectible.
• The bad debt expense is entered as a debit to increase the expense, whereas the allowance for doubtful accounts is a credit to increase the contra-asset balance.

The bad debt expense account is created to reflect the actual loss and is posted directly to the income statement. The direct write-off method does not consider potential losses and can distort or misrepresent the financial picture. For example, say on December 31, 2022, your allowance account shows a credit balance of $2,000. You calculate your allowance using the accounts receivable aging method shown above and decide your allowance should be $5,750. Accountants
have typically relied on accounts receivable aging as the primary
tool for evaluating collectibility.

Are Allowance for Doubtful Accounts a Current Asset?

In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. Accordingly, the company credits the accounts receivable account by $40,000 to reduce the amount of outstanding accounts receivable, and debits the Allowance for Doubtful Accounts by $40,000. The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. The company would then record a journal entry at the end of the accounting period that includes a debit to the bad debt expense account for $3,000 and a credit to the allowance for doubtful accounts for $3,000.

• GAAP allows for this provision to mitigate the risk of volatility in share price movements caused by sudden changes on the balance sheet, which is the A/R balance in this context.
• The balance in Service Revenues will increase during the year as the account is credited whenever a sales invoice is prepared.
• The first step in accounting for the allowance for doubtful accounts is to establish the allowance.
• The Allowance for Doubtful Accounts is a contra asset account that is used with the balance in Accounts Receivable to report the net realizable value of the receivables.
• The outstanding balance of $2,000 that Craft did not repay will remain as bad debt.

Otherwise, it could be misleading to investors who might falsely assume the entire A/R balance recorded will eventually be received in cash (i.e. bad debt expense acts as a “cushion” for losses). The Allowance for Doubtful Accounts is a contra-asset account that estimates the future losses incurred from uncollectible accounts receivable (A/R). In the example above, we estimated an arbitrary number for the allowance for doubtful accounts. There are two primary methods for estimating the amount of accounts receivable that are not expected to be converted into cash.

What is the Allowance for Doubtful Accounts?

Estimating an allowance for doubtful accounts is an essential aspect of accounting for companies. To do this, companies use various methods to calculate the estimated number of uncollectible accounts that need to be reserved. The Pareto analysis method relies on the Pareto principle, which states that 20% of the customers cause 80% of the payment problems.

Historical data

The company now has a better idea of which account receivables will be collected and which will be lost. For example, say the company now thinks that a total of $600,000 of receivables will be lost. The company must record an additional expense for this amount to also increase the allowance’s credit balance. Assume a company has 100 clients and believes there are 11 accounts that may go uncollected.

A credit of $375 will need to be entered into the asset account in order to reduce the balance from $1,100 to $725. Because Allowance for Doubtful Accounts is a balance sheet account, its ending balance will carry forward to the next accounting year. Because Bad Debts Expense is an income statement account, its balance will not carry forward to the next year. To record the payment itself, you would then debit cash, and credit accounts receivable. There are a variety of allowance methods that can be used to estimate the allowance for doubtful accounts.

If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400. Hence, we can make an estimation that $300 ($10,000 x 3%) of the total credit sales will become bad debt. In this case, we need to make allowance for doubtful accounts with this amount and record this $300 into the bad debt expense during the period to comply with the matching principle of accounting. On the other hand, the bad debt expense is an expense item on the income statement. Likewise, this journal entry decreases total assets on one side and increases total expenses on another side.

Everything You Need To Master Financial Modeling

This would split accounts receivable into three past- due categories and assign a percentage to each group. At the end of each accounting period, we need to record the expected losses due to uncollectible accounts into the allowance for doubtful accounts on the balance sheet. At the same time, we need to recognize it as an expense during the accounting period by recording the same amount of the expected losses into the bad debt expense on the income statement. In this article, we shall discuss the doubtful accounts, its main journal entry as well as adjusting entries. An allowance for doubtful accounts, or bad debt reserve, is a contra asset account (either has a credit balance or balance of zero) that decreases your accounts receivable.

Pareto Analysis Method

The adjusting entry above signifies an increase in both the accounts receivable and the allowance for doubtful accounts which results from the debt repayment. Hence by this adjusting journal entry, the amount that was previously written off due to nonpayment gets reversed. The provision creating a bad debt reserve or allowance for doubtful accounts estimates the likely uncollectable payments from unpaid invoices. A higher level of doubtful accounts means higher credit risk, and financial statements could be reporting inflated revenues as they include all credit sales, too, due to the principles of the accrual accounting method.

As per IFRS 9, a company needs to estimate the “Expected Credit Losses” based on clear and objective evaluation criteria, which need to be documented by the management. Mr. Arora is an experienced private equity investment professional, with experience working across multiple markets. Rohan has a focus bookkeeping vs accounting in particular on consumer and business services transactions and operational growth. Rohan has also worked at Evercore, where he also spent time in private equity advisory. Recovering an account may involve working with the debtor directly, working with a collection agency, or pursuing legal action.