Allowance for doubtful accounts definition
/What is the Allowance for Doubtful Accounts?
The allowance for doubtful accounts is paired with and offsets accounts receivable. It represents management’s best estimate of the amount of accounts receivable that will not be paid by customers. When the allowance is subtracted from accounts receivable, the remainder is the total amount of receivables that a business actually expects to collect. Actual results may vary from management’s expectations for accounts receivable collections.
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 for doubtful accounts 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.
How to Estimate the Allowance for Doubtful Accounts
Estimating the allowance for doubtful accounts helps businesses anticipate potential credit losses from customers who may not pay. The main methods used are:
Percentage of sales method. This method estimates bad debt expense as a fixed percentage of total credit sales, based on historical data. Businesses apply a predetermined percentage (e.g., 2%) to total sales or credit sales to determine the allowance amount. This approach is simple and aligns bad debt expense with revenue in the same period. However, it does not consider the age or risk level of individual accounts, which may reduce accuracy.
Percentage of accounts receivable method. This method applies a fixed percentage to the ending accounts receivable balance to estimate doubtful accounts. The percentage is often based on past collection trends and industry standards. Unlike the percentage of sales method, this approach focuses on outstanding balances rather than revenue, providing a more direct estimate of potential losses. However, it assumes all accounts receivable carry the same risk, which may not always be the case.
Aging of accounts receivable method. This method categorizes receivables based on how long they have been outstanding and applies different percentages of expected uncollectability to each category. Older receivables typically have a higher probability of being uncollectible, so businesses apply increasing percentages to overdue balances. This approach provides a more accurate estimate of doubtful accounts by assessing the risk associated with different aging periods. However, it requires more detailed tracking and analysis of accounts receivable.
Historical trend and statistical modeling. Some businesses use past trends, economic data, and statistical models to estimate doubtful accounts. Advanced techniques, such as regression analysis or machine learning, can predict bad debt based on factors like customer payment history, industry trends, and macroeconomic conditions. This method is highly customized and data-driven, improving accuracy in forecasting credit losses. However, it requires substantial data collection, analysis, and expertise, making it more complex than traditional estimation methods.
Each method has its advantages, and companies often use a combination of these approaches for a more reliable estimate of their allowance for doubtful accounts.
Presentation of the Allowance for Doubtful Accounts
In the firm's balance sheet, the allowance for doubtful accounts appears as a contra account that is paired with and offsets the accounts receivable line item. An example appears in the following exhibit.
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Example of the Allowance for Doubtful Accounts
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).
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.