Doubtful accounts represent the amount of money expected to be uncollectible by a vendor. Adding an allowance for doubtful accounts is an excellent way for the management to get a clearer picture of the company’s total assets. However, if the money remains unpaid, it will eventually be classified as “bad debt.”
What is an allowance for a doubtful account?
An allowance for doubtful accounts is considered a “contra asset,” as it reduces the amount of an asset; here, it is accounts receivable. Also known as the contra account, the allowance for doubtful accounts is an estimated percentage of the accounts receivable that are not expected to be collectible. However, this is not even a close representation of the actual payment behavior of customers, as it may differ substantially. The allowance, also known as a bad debt reserve, provides a picture of management’s estimate of the expected uncollectible accounts receivable.
What is a Contra Account?
A contra asset or contra account is an account used to bring down the value of a related account when the two are accumulated together. A contra account’s primary task is to balance out the opposite associated account. A simple example of contra account will be accumulated depreciation, as it reduces the fixed asset balances.
How do recording doubtful accounts help in accounting?
As per accrual-basis accounting, as the sale improves, recording the allowance for doubtful accounts enhances the accuracy of financial reports. An estimated bad debt expense is appropriately matched against the related sale, providing accurate insight into revenue and expenses for a given period. It also prevents large swings in operating results by writing off the uncollectible amount as a bad debt expense.
Business entities that are constantly providing goods or services on “credit” should consider using an allowance for doubtful accounts since they have experience collecting these accounts. Ideally, the reporting period for recording expenses is the same as reporting revenue, which is annual. Here is an accounting entry made in the accounting statement according to the reporting cycle.
- Debit- Bad Debt Expense
- Credit– Allowance for Doubtful Accounts
How Do You Calculate Allowance for Doubtful Accounts?
There are a couple of ways through which a company can calculate an estimated amount for its allowance for doubtful accounts. Here are a few:
1. Risk Classification Method:
In this method, a company assigns a risk rating to every customer, like low, medium, or high. Then they determine a percentage for each category that reflects the chances of customers in that category paying. These percentages are further multiplied by the total sales in each customer category. The resulting three separate amounts are added and converted to a percentage based on the total sales amount.
The risk classification method is tricky and can be inaccurate, as it’s hard to classify new customers. Sometimes existing customers also end up with unexpected behavior and fall into the risky category.
2. Aging or Historical Percentage Method:
This is where a company uses historical data of defaults to calculate the allowance for doubtful accounts. The company considers the past five years’ data of unpaid accounts and then computes the total unpaid invoices for each year in a percentage form. The company now looks at total sales hereon and then multiplies it by the percentage. The result is the new number for allowance for doubtful accounts.
3. Pareto Analysis Method:
This method is also known as the “80/20” rule and is ideally used by business entities with a small number of large invoice balances. Here, the doubtful account balance combines the above two methods, where the risk method is typically used for the larger clients (80%), and the historical method is used for the smaller clients (20%).
Difference between the allowance for doubtful accounts and bad debts
|Allowance for Doubtful Accounts||Bad Debts|
|Allowance for Doubtful Accounts is a contra asset account, where the company assumes that a certain amount might turn into bad debts.||Bad debt is the amount that can no longer be collected by the business entity and can be identified.|
|This amount is accounted for in the company’s income statement from the beginning.||This may come as a surprise on the balance sheet.|
|This is a doubtful debt.||This is a doubtful debt that has been written off as uncollectible.|
|Allowance for Doubtful Accounts is the first step to account for future bad debts.||Bad Debt could result from an uncollectible amount from the doubtful account or may even surprise the management.|
Does Allowance for Doubtful Accounts Get Closed?
The simple answer would be, no, the allowance for doubtful accounts does not get closed and carries forward the balance to the following year. Like most accounts, this is a permanent account on the company’s balance sheet. However, bad debt expenses reflected on a company’s income statement do reset and close.
Is Allowance for Doubtful Accounts an Asset?
Yes, doubtful accounts are an asset. This amount is reflected on a company’s balance sheet in the asset section as “Allowance for Doubtful Accounts,” directly below the “Accounts Receivable.” Recording this amount in the balance sheet brings the extent to which the company should expect a bad debt immediately to the management’s attention. This account reflects a zero or credit balance; hence it is considered an asset.
This post covers everything you need to know about the allowance for doubtful accounts. It is an asset category account, which takes place in the balance sheet and is accounted for to make room for future bad debts.
Also, check the different examples of non-operating expenses.