Overview of the Allowance for Doubtful Accounts
The allowance for doubtful accounts is a reduction of the total amount of accounts receivable appearing on a company’s balance sheet, and is listed as a deduction immediately below the accounts receivable line item. This deduction is classified as a contra asset account.
The allowance for doubtful accounts represents management’s best estimate of the amount of accounts receivable that will not be paid by customers. It does not necessarily reflect subsequent actual experience, which could differ markedly from expectations. If actual experience differs, then management adjusts its estimation methodology to bring the reserve more into alignment with actual results.
Estimation Techniques for the Allowance for Doubtful Accounts
There are several possible ways to estimate the allowance for doubtful accounts, which are:
- Risk classification. Assign a risk score to each customer, and assume a higher risk of default for those having a higher risk score.
- Historical percentage. If a certain percentage of accounts receivable became bad debts in the past, then use the same percentage in the future. This method works best for large numbers of small account balances.
- Pareto analysis. Review the largest accounts receivable that make up 80% of the total receivable balance, and estimate which specific customers are most likely to default. Then use the preceding historical percentage method for the remaining smaller accounts. This method works best if there are a small number of large account balances.
You can also evaluate the reasonableness of an allowance for doubtful accounts by comparing it to the total amount of seriously overdue accounts receivable, which are presumably not going to be collected. If the allowance is less than the amount of these overdue receivables, the allowance is probably insufficient.
You should review the balance in the allowance for doubtful accounts as part of the month-end closing process, to ensure that the balance is reasonable in comparison to your latest bad debt forecast. For companies having minimal bad debt activity, a quarterly update may be sufficient.
Companies have been known to fraudulently alter their financial results by manipulating the size of this allowance. Auditors look for this issue by comparing the size of the allowance to gross sales over a period of time, to see if there are any major changes in the proportion.
Accounting for the Allowance for Doubtful Accounts
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.
For example, 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). The entry is:
|Bad Debt Expense
|Allowance for Doubtful Accounts||100,000|
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. The entry is:
|Allowance for Doubtful Accounts
| Accounts Receivable
A few months later, a collection agency succeeds in collecting $15,000 of the funds that the company had already written off. The company can now reverse part of the previous entry, thereby increasing the balances of both accounts receivable and the allowance for doubtful accounts. The entry is:
|Allowance for Doubtful Accounts||15,000|
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.
The allowance for doubtful accounts is also known as the allowance for bad debt and bad debt allowance.