What is the Allowance for Doubtful Accounts?

The allowance for doubtful accounts is a reduction of the total amount of accounts receivable appearing on a company’s balance sheet. This deduction is classified as a contra asset account, so it is paired with and offsets the accounts receivable line item. 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.

Presentation of the Allowance for Doubtful Accounts

The allowance for doubtful accounts is a contra asset account, and so is listed as a deduction immediately below the accounts receivable line item in the balance sheet. It may be aggregated into the accounts receivable line item, whereby it is not stated separately.

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How to Estimate the Allowance for Doubtful Accounts

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

Estimation by risk classification. Assign a risk score to each customer, and assume a higher risk of default for those having a higher risk score.
Estimation by 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. This approach can work well when economic conditions persist over several years, so that loss rates can be expected to persist over time. It also works well if the company’s credit policy does not change during the measurement period. However, if economic conditions decline in the current period, or management loosens the credit policy, then the bad debt rate in the current period will likely exceed what was experienced in prior periods. Or, in the reverse situation, the bad debt rate in the current period will likely drop below what was experienced in prior periods.
Estimation by 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.

Fraudulent Use of the Allowance for Doubtful Accounts

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.

Accounting for the Allowance for Doubtful Accounts

If a company is using the accrual basis of accounting, it should record an allowance for doubtful accounts, since it provides an estimate of future bad debts that improves the accuracy of the company’s financial statements. Also, by recording the allowance at the same time it records a sale, a company is properly matching the projected bad debt expense against the related sale in the same period, which provides an accurate view of the true profitability of a sale.

For example, a company records $10,000,000 of sales to several hundred customers, and projects (based on historical experience) that it will incur 1% of this amount as bad debts, though it does not know exactly which customers will default. It records the 1% of projected bad debts as a $100,000 debit to the Bad Debt Expense account and a $100,000 credit to the Allowance for Doubtful Accounts. The bad debt expense is charged to expense right away, and the allowance for doubtful accounts becomes a reserve account that offsets the account receivable of $10,000,000 (for a net receivable outstanding of $9,900,000). The entry is:

	Debit	Credit
Bad Debt Expense	100,000
Allowance for Doubtful Accounts		100,000

Later, several customers default on payments totaling $40,000. 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. This entry reduces the balance in the allowance account to $60,000. The entry does not impact earnings in the current period. The entry is:

	Debit	Credit
Allowance for Doubtful Accounts	40,000
Accounts Receivable		40,000

A few months later, a collection agency succeeds in collecting $15,000 of the funds that the company had already written off. The company can now reverse part of the previous entry, thereby increasing the balances of both accounts receivable and the allowance for doubtful accounts. The entry is:

	Debit	Credit
Accounts Receivable	15,000
Allowance for Doubtful Accounts		15,000

Other Issues

The only impact that the allowance for doubtful accounts has on the income statement is the initial charge to bad debt expense when the allowance is initially funded. Any subsequent write-offs of accounts receivable against the allowance for doubtful accounts only impact the balance sheet.