How to Record an Allowance for Doubtful Accounts

Posted by mhengineering in Bookkeeping

The allowance method follows GAAP matching principle since we estimate uncollectible accounts at the end of the year. We use this estimate to record Bad Debt Expense and to setup a reserve account called Allowance for Doubtful Accounts (also called Allowance for Uncollectible Accounts) based on previous experience with past due accounts. We can calculate this estimates based on Sales (income statement approach) for the year or based on Accounts Receivable balance at the time of the estimate (balance sheet https://investrecords.com/the-importance-of-accurate-bookkeeping-for-law-firms-a-comprehensive-guide/ approach). The allowance for doubtful accounts is an estimate of money owed to your business that you won’t be able to collect from customers. If your business issues accrual basis financial statements, you should calculate an allowance for doubtful accounts and show it on your company’s balance sheet. And because the balance in the allowance for doubtful accounts reduces or offsets your accounts receivable balance, using this contra asset account will contribute to more accurate financial statements.

• There is one more point about the use of the contra account, Allowance for Doubtful Accounts.
• The same entry is made, under both Balance Sheet and Income Statement approaches.
• An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable.
• So you should do everything you can to avoid losing money on customers who don’t pay their invoices.
• Multiplying the default rate with the total AR will give you an estimate of bad debt expense.
• The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the desired credit balance (the target) in the Allowance for Uncollectible Accounts.

This method works best if there are a small number of large account balances. 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 law firm bookkeeping in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400. The sales method applies a flat percentage to the total dollar amount of sales for the period.

Percentage of Outstanding Receivables

But, you’ll want to do everything in your power to prevent receivables from becoming uncollectible before things get to that point. How you determine your AFDA may also depend on what’s considered typical payment behavior for your industry. As much as you would love to collect on every invoice you issue, that doesn’t always happen. Problems such as disputes, miscommunications, and customer insolvency make achieving a 100% collection rate challenging. Get instant access to video lessons taught by experienced investment bankers.

• Accrual-basis accounting is required for a company to be in compliance with GAAP.
• In this example, the $85,200 total is the net realizable value, or the amount of accounts anticipated to be collected.
• It may be obvious intuitively, but, by definition, a cash sale cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency.
• In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the accuracy of financial reports.

However, it’s dependent on maintaining a small, consistent customer base that can be measured, with calculation efforts increasing as your client base grows. Typically, larger businesses rely on one of the first two methods due to the complexity of running these assessments across a big customer pool. The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the desired credit balance (the target) in the Allowance for Uncollectible Accounts. Allowance for doubtful accounts falls under the contra-asset section, which means it will either be zero or negative.

The Allowance Method for Uncollectible Accounts

The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance. 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. In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. Estimating uncollectible accounts Accountants use two basic methods to estimate uncollectible accounts for a period. The first method—percentage-of-sales method—focuses on the income statement and the relationship of uncollectible accounts to sales.

Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period. BWW estimates 15% of its overall accounts receivable will result in bad debt. With the account reporting a credit balance of $50,000, the balance sheet will report a net amount of $9,950,000 for accounts receivable. This amount is referred to as the net realizable value of the accounts receivable – the amount that is likely to be turned into cash.

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The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified. Once this account is identified as uncollectible, the business will record a reduction to the customer’s accounts receivable and an increase to bad debt expense for the exact amount uncollectible. To predict your company’s bad debts, create an allowance for doubtful accounts entry.

Also note that it is a requirement that the estimation method be disclosed in the notes of financial statements so stakeholders can make informed decisions. Allowance for Doubtful Accounts decreases (debit) and Accounts Receivable for the specific customer also decreases (credit). Allowance for doubtful accounts decreases because the bad debt amount is no longer unclear. Accounts receivable decreases because there is an assumption that no debt will be collected on the identified customer’s account. Being proactive with your e-invoicing and collections process is the easiest way to reduce the number of doubtful or delinquent accounts. A reliable AR automation solution can help you achieve better cash flow, lower bad debt, and improve profits by analyzing customer behavior, risk, and past data.

Writing Off an Account under the Allowance Method

The information in an aging schedule also is useful to management for other purposes. Analysis of collection patterns of accounts receivable may suggest the need for changes in credit policies or for added financing. For example, if the age of many customer balances has increased to days past due, collection efforts may have to be strengthened. Or, the company may have to find other sources of cash to pay its debts within the discount period.

• Let’s look at what is reported on Coca-Cola’s Form 10-K regarding its accounts receivable.
• This means that in order to present an accurate assessment of A/R, we need to determine how many A/R are not receivable in full.
• It is usually added to the total accounts receivable to give the net AR value.
• However, the balance sheet would show $100,000 accounts receivable less a  $5,300 allowance for doubtful accounts, resulting in net receivables of  $ 94,700.
• The historical percentage method works best if you have a relatively small customer base and straightforward billing cycles.
• Doubtful accounts are considered to be a contra account, meaning an account that reflects a zero or credit balance.

For this reason, companies that are required to adhere to GAAP do not use this method to report bad debt. Producing financial statements in compliance with GAAP (Generally Accepted Accounting Principles) is a requirement for public companies listed on a US Exchange. The matching principle requires that revenues be matched to their related expense within an accounting period. To approximate this as much as possible, a company must rely on the accrual-basis accounting method to periodically estimate certain revenues and expenses. Accrual-basis accounting is required for a company to be in compliance with GAAP. In the case of uncollectible accounts, there is often a big gap of time between a credit sale and the company realizing that the credit sale cannot be collected.

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