Doubtful accounts are overdue invoices that your company does not anticipate being able to pay before the end of the accounting period. Doubtful accounts are therefore estimated amounts of receivables that are unlikely to ever reach your bank account. A doubtful account can turn into a bad debt after a certain amount of time passes without being paid, which is ultimately a cost that is borne by your company.
With this in mind, accounting teams frequently rely on something called an “allowance for doubtful accounts” to produce more accurate financial statements. “Another name for the allowance for doubtful accounts is ADA or a bad debt reserve. This sum enables your company to prepare for uncollectible debts that have an effect on your budget and bottom line.
Allowance For Doubtful Accounts – Accounts Receivable
Examples of using allowance for doubtful accounts
Take into account the following instances of how businesses might make use of allowance for doubtful accounts:
Company ABC lists 50 credit-buying clients and the total amount owed as of September. 30, 2021, is $100,000. It records this sum as accounts receivable on a balance sheet. This account’s objective is to forecast the number of customers who might default on their debt, allowing the business to more accurately account for debt.
Company ABC anticipates that the 20% of the debt, or $20,000, will not be repaid. The business must estimate the amount it won’t be able to pay off to protect itself from losses even though it may eventually pay the debt. In this case, the company debits the amount for which it won’t be able to collect payment as a bad debt expense. If the net realizable value of accounts receivable on the balance sheet is $80,000, then the allowance of accounts will be as follows:
So, the allowance for doubtful accounts would be $20,000.
Company ABC receives payment from a client for a $2,200 debt that was previously written off as a bad debt. ABC reverses the account by entering:
So, the allowance for doubtful accounts would be $2,200.
The accounts receivable debit balance for Company ABC as of September 30 was $100,000. 30, 2021. It discovered $20,000 of this debt is more than 100 days past due using the aging method, and it anticipates that $10,000 of these accounts receivables will go unpaid. To reflect this, it modifies the balance sheet’s accounts receivable.
To do this, it divides the accounts receivable by the allowance, or $100,000 – $10,000, leaving a net amount of $90,000. Their balance sheet will appear as:
So, the allowance for doubtful accounts would be $10,000.
What is an allowance for doubtful accounts?
On a company’s balance sheet, accounts receivable are reduced by an allowance for doubtful accounts, which is an allowance for bad debt. It’s a contra asset account, which is an account with a credit balance that reflects the true value of accounts receivable or a balance of zero. The account is a journal entry that lowers the total accounts receivable on a company balance sheet to better reflect the amount of money it can collect.
Where to place allowance for doubtful accounts in a balance sheet
Companies list the allowance of doubtful accounts section under assets on a balance sheet. Its placement immediately beneath the accounts receivable item suggests that this is the sum of money the company anticipates receiving. Any sum added as an allowance for doubtful accounts is a deduction that enables the business to see how much bad debt there is.
For instance, Company ABC from the earlier examples might include the following in the allowance for doubtful accounts:
Creating a journal entry for allowance for doubtful accounts
Businesses create journal entries for the allowance of doubtful accounts to track bad debt and follow-up on payments owed. It credits the amount it anticipates being paid while debiting bad debt expenses in the journal entry.
Businesses credit their account receivable and debit the allowance for doubtful accounts when a doubtful debt becomes a bad debt. Customers do, however, occasionally pay the amount written off as bad debts. When this occurs, the manager of the balance sheet reverses the account by debiting the receivables.
The difference between doubtful debt and bad debt
Bad debt is a debt that you have acknowledged as being unpaid by the customer. Your business was supposed to receive this money, but it has yet to be collected. Payments that remain unpaid turn into bad debts. A business can still collect a questionable debt, but doesn’t anticipate getting paid for it. There is still a chance that your business will be paid, but you anticipate that it will eventually result in a bad debt.
Who uses allowance for doubtful accounts?
Establishing an allowance for doubtful accounts helps business professionals who offer credit lines to their clients’ balance sheets by increasing the accuracy of accounts receivable.
Allowance for Doubtful Accounts is a tool used by accountants, business owners, and managers to estimate payments that may not be received. This system predicts and guards against inaccurate financial statements for businesses that frequently provide goods and services on credit and have knowledge of the likelihood of getting paid.
Depending on the business and its reporting cycles, the right time to record this type of entry varies, but you should think about doing it during the same reporting period or year.
Reporting the allowance for doubtful accounts concurrently with the sale can increase the accuracy of the financial reports. This may produce a view of the reporting cycles’ revenues and costs that is more accurate. Additionally, it can prevent significant variations in the business’s operating results.
How to calculate the allowance for doubtful accounts
The following are some of the most crucial and frequently employed techniques for determining the allowance for doubtful accounts:
1. Risk classification
Give each client a risk score based on how likely it is that they will not pay their debts using this approach. Customers who are more likely to miss a payment on their credit card will have a higher score.
For instance, based on the likelihood that they will default, Company ABC can divide its clients’ risk into three categories, such as low, medium, and high. The company can estimate its allowance for doubtful accounts based on the proportion of each category to the total amount owed.
2. Historical percentage
One of the more reliable methods to determine a provision for doubtful accounts may be through experience. You can make future predictions using the percentage of accounts receivable that turned into bad debts in the past. This knowledge can make your accounting more accurate and better prepare you in case you need to make an allowance for shaky accounts.
3. Pareto analysis
If there are only a few large account balances, you can review the receivables that account for more than 80% of the balance and determine which of the customers there are likely to default. For the other, smaller account balances, employ the historical percentage method.
Another choice for determining and recording a provision for doubtful accounts is to contrast it with receivables that are already far past due and likely won’t be collected. Although this approach is less foresighted than others, it can still give your company useful information. Consider reevaluating your accounts if the anticipated allowance is less than the past-due accounts.
5. Percentage of sales
This method applies a flat percentage to the total amount of accounts receivable for the period to determine the allowance for doubtful accounts.
For instance, if Company ABC’s average bad debt for the first quarter was $20,000 and the business generated $500,000 in sales, bad debt expense would be 4% of sales. Based on sales during a specific time period, the company uses this percentage to estimate the amount of bad debt.
6. Accounts receivable aging
Grouping all of the company’s outstanding accounts receivable based on the maturity of the debt and then applying various percentages to each group are two additional techniques for calculating the allowance for doubtful accounts. The total would reflect the predicted unpaid amount. This can help your planning and budgeting processes.
Allowance for doubtful accounts methods
Here are some illustrations of how to determine and record an allowance for doubtful accounts using various techniques:
Accounts receivable aging method
According to data from Company ABC, 10% of receivables are more than 30 days past due and 5% are less than 30 days past due. These accounts are typically not collected. They are currently awaiting payment for credit balances totaling $10,000 and $2,000, both of which are over 30 days old.
By dividing the accounts receivable by the appropriate percentage for the aging period and combining those two sums, it estimates the allowance for doubtful accounts.
Its estimated allowance for doubtful accounts is $700.
*Business ABC has discovered that historically, 2% of its credited sales go unpaid. Their total amount of accounts receivable is currently $50,000. By dividing the amount owed by the percentage, they calculate the allowance for doubtful accounts.
Its estimated allowance for doubtful accounts is $1,000.
How is allowance for doubtful accounts recorded on the balance sheet?
Recording an allowance for doubtful accounts on the balance sheet You must include the amount when you make an allowance for doubtful accounts on your company’s balance sheet. Record it as an expense on your income statement if the questionable debt eventually becomes a bad debt.
What is the difference between bad debt and allowance for doubtful accounts?
Doubtful accounts are an asset. The sum is shown as “Allowance For Doubtful Accounts” on a company’s balance sheet, in the assets section, immediately below the line item for “Accounts Receivable.” Doubtful accounts are categorized as contra accounts, which are accounts that show a zero or positive balance.