Allowance for Doubtful Accounts

What is the Allowance for Doubtful Accounts?

The allowance reflects management’s best estimate of the amount of accounts receivable that customers will not pay. The allowance for doubtful accounts is commonly known as the bad debt allowance.

Overview

Allowance for doubtful accounts is a contra asset that reduces the total amount of accounts receivable. It is important to note that it does not necessarily reflect subsequent payment of receivables, which may differ from expectations. If actual bad debts differ from the estimated amount, management must adjust its estimate to align the reserve with actual results.

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.

Working Example

Below is an example that demonstrates how the allowance for doubtful accounts works. Blustrata Inc. records $50,000,000 in sales. Based on historical reporting, bad debts typically average 2% of receivables. Note that Blustrata Inc. does not know which customers will default.

Blustrata Inc. then records the 2% of receivables as projected bad debts, making a $1,000,000 debit to the Bad Debt Expense account and a $1,000,000 credit to the Allowance for Doubtful Accounts. The bad debt expense is charged to expenses right away. The allowance for doubtful accounts becomes a reserve account that offsets the accounts receivable total of $50,000,000 (for a net receivable outstanding of $49,000,000). Here is the entry:

Several weeks later, a few customers defaulted on payments totaling $300,000. Blustrata Inc. then credits the accounts receivable account by 0,000, reducing the number of outstanding accounts receivable, and debits the Allowance for Doubtful Accounts by 0,000. This entry reduces the balance in the allowance account to $700,000. Please note that the entry has no impact on earnings in the current period. The entry is:

Six months later, Redfin Debt Collectors succeeded in collecting $150,000 of previously written-off receivables. Blustrata Inc can now reverse part of the previous entry, increasing the balances of both accounts receivable and the allowance for doubtful accounts. The entry is:

More Detail

The allowance can be calculated using different methodologies, and a straightforward way is to use historical context. If a certain percentage of accounts receivable is typically written off, it’s reasonable to use that percentage as an estimate.

Below are two methods for estimating the amount of accounts receivable that are not expected to be converted into cash.

1. Percentage of Credit Sales – If a company and/or industry reported a long-run average of 4% of credit sales as uncollectible, the company would enter 4% of each period’s credit sales as a debit to bad debt 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.

The allowance for doubtful accounts is as follows:

($320,000 x 1%) + ($330,000 x 15%) + ($150,000 x 25%) + ($250,000 x 30%) = $165,200

Conclusion

The allowance for doubtful accounts ensures that the financial statements are prudent, by reflecting management’s expectations – not just contractual amounts – in the balance sheet. It, therefore, helps analysts make better predictions of the cash flows the company expects to receive from customers.