Earn your certification as a Financial Modeling & Valuation Analyst (FMVA)™. Register today!

Allowance for Doubtful Accounts

The amount of accounts receivable that a company does not expect to collect

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 allowance for doubtful accounts represents the value of accounts receivable that a company does not expect to receive payment for.

 

Allowance for Doubtful Accounts theme

 

Purpose of the Allowance for Doubtful Accounts

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 for said customers, 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:

 

Date Account Title Debit Credit
June 30, 2017 Bad Debts Expense $50,000
Allowance for Doubtful Accounts $50,000

 

With allowance for doubtful accounts 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)

 

Date Account Title Debit Credit
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 of $10,000 on June 25 informs the company on August 3 that it already filed for bankruptcy and would not be able to pay the amount owed. The company would now write off the customer’s account balance of $10,000.

To write off the customer’s account balance of $10,000:

 

Date Account Title Debit Credit
Aug. 3, 2017 Allowance for Doubtful Accounts $10,000
Accounts Receivable $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 debts expense remains the same and is not affected by the write-off. The bad debts 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 now reinstate the account that was initially written-off on August 3.

To reverse the write-off:

 

Date Account Title Debit Credit
Sept. 10, 2017 Accounts Receivable $10,000
Allowance for Doubtful Accounts $10,000

 

To record the amount paid to the company from the customer:

 

Date Account Title Debit Credit
Sept. 10, 2017 Cash $10,000
Accounts Receivable $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 uncollectible 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:

 

Allowance for Uncollectible Accounts example calculation

 

To calculate the allowance for doubtful accounts:

($5000 x 1%) + ($25,000 + 20%) + ($6,000 + 35%) + ($54,000 + 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)

 

Date Account Title Debit Credit
Dec. 31, 2017 Bad Debts Expense $34,550
Allowance for Doubtful Accounts $34,550

 

Related Reading

Thank you for reading this guide on the accounting methods for allowance for doubtful accounts. To learn more and boost your accounting career, these additional resources will be helpful:

Free Accounting Courses

Learn accounting fundamentals and how to read financial statements with CFI's free online accounting classes. These courses will give the confidence you need to perform world-class financial analyst work. Start now!  

Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!