What is the Allowance for Doubtful Accounts?
The allowance for doubtful accounts is a contra-asset account that is associated with accounts receivable and serves to reflect the true value of accounts receivable. The amount represents the estimated value of accounts receivable that a company does not expect to receive payment for.
Purpose of the Allowance
For example, say a company lists 100 customers who purchase on credit and the total amount owed is $1,000,000. The $1,000,000 will be reported on the balance sheet as accounts receivable. The purpose of the allowance for doubtful accounts is to estimate how many customers out of the 100 will not pay the full amount they owe. Rather than waiting to see exactly how payments work out, the company will debit a bad debt expense and credit allowance for doubtful accounts.
Example of Allowance for Doubtful Accounts
Using the example above, let’s say that a company reports an accounts receivable debit balance of $1,000,000 on June 30. The company anticipates that some customers will not be able to pay the full amount and estimates that $50,000 will not be converted to cash. Additionally, the allowance for doubtful accounts in June starts with a balance of zero.
To account for the estimated $50,000 that will not be converted to cash:
|June 30, 2017||Bad Debts Expense||$50,000|
|Allowance for Doubtful Accounts||$50,000|
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. The debit to bad debts expense would report credit losses of $50,000 on the company’s June income statement.
Above, we assumed that the allowance for doubtful accounts began with a balance of zero. If instead, the allowance for uncollectible accounts began with a balance of $10,000 in June, we would make the following adjusting entry instead:
$50,000 – $10,000 = $40,000 (adjusting entry)
|June 30, 2017||Bad Debts Expense||$40,000|
|Allowance for Doubtful Accounts||$40,000|
Example of Writing off an Account
Later, a customer who purchased goods totaling $10,000 on June 25 informs the company on August 3 that it already filed for bankruptcy and will not be able to pay the amount owed. The company would then write off the customer’s account balance of $10,000.
To write off the customer’s account balance of $10,000:
|Aug. 3, 2017||Allowance for Doubtful Accounts||$10,000|
After writing off the bad account, the net amount for accounts receivable remains the same: $9,950,000 ($9,990,000 – $40,000). In addition, the bad debt expense remains the same and is not affected by the write-off. The bad debt expense recorded on June 30 already anticipated a credit loss.
Example of Recovering an Account
The customer who filed for bankruptcy on August 3 manages to pay the company back the amount owed on September 10. The company would then reinstate the account that was initially written-off on August 3.
To reverse the write-off:
|Sept. 10, 2017||Accounts Receivable||$10,000|
|Allowance for Doubtful Accounts||$10,000|
To record the amount paid to the company from the customer:
|Sept. 10, 2017||Cash||$10,000|
Estimating the Amount of Allowance for Doubtful Accounts
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.
1. Percentage of Credit Sales
The percentage of credit sales method is explained as follows: If a company and the industry reported a long run average of 2% of credit sales being uncollectible, the company would enter 2% of each period’s credit sales as a debit to bad debts expense and a credit to allowance for doubtful accounts.
2. Accounts Receivable Aging
The accounts receivable aging method is a report that lists unpaid customer invoices by date ranges and applies a rate of default to each date range.
Example of an accounts receivable aging chart:
To calculate the allowance for doubtful accounts:
($5000 x 1%) + ($25,000 x 20%) + ($6,000 x 35%) + ($54,000 x 60%) = $39,550
If we assume that the allowance for uncollectible accounts showed a credit balance of $5,000 before adjustment, we will make the following adjusting entry:
$39,550 – $5,000 = $34,550 (adjusting entry)
|Dec. 31, 2017||Bad Debts Expense||$34,550|
|Allowance for Doubtful Accounts||$34,550|
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