Allowance for Doubtful Accounts: Deduction Technique Explained
An allowance for doubtful accounts is a technique used by a business to show the total amount from the goods or products it has sold that it does not expect to receive payments for. This allowance is deducted against the accounts receivable amount, on the balance sheet.
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What Are Doubtful Accounts?
Doubtful accounts represent the amount of money deemed to be uncollectible by a vendor. Adding an allowance for doubtful accounts to a company’s balance sheet is particularly important because it allows a company’s management to get a more accurate picture of its total assets.
Eventually, if the money remains unpaid, it will become classified as “bad debt”. This means the company has reached a point where it considers the money to be permanently unrecoverable, and must now account for the loss. Bad debt will be reflected on a company’s income statement. However, without doubtful accounts having first accounted for this potential loss on the balance sheet, a bad debt amount could have come as a surprise to a company’s management. Especially since the debt is now being reported in an accounting period later than the revenue it was meant to offset.
Is Allowance for Doubtful Accounts an Asset?
Doubtful accounts are an asset. The amount is reflected on a company’s balance sheet as “Allowance For Doubtful Accounts”, in the assets section, directly below the “Accounts Receivable” line item.
Doubtful accounts are considered to be a contra account, meaning an account that reflects a zero or credit balance. In other words, if an amount is added to the “Allowance for Doubtful Accounts” line item, that amount is always a deduction.
Recording the amount here allows the management of a company to immediately see the extent of the expected bad debt, and how much it is offsetting the company’s account receivables.
How Do You Calculate Allowance for Doubtful Accounts?
There are a number of ways a company can estimate its allowance for doubtful accounts. It can be done through the:
Risk Classification Method
This is where a company assigns a risk rating to every customer: low, medium or high. Then the company determines a percentage for each category that reflects the likelihood of customers in that category paying.
These percentages are multiplied by total sales in each customer category, then the resulting three separate dollar amounts are added up and converted to a percentage based on the total sales amount.
That percentage can now be applied to the current accounting period’s total sales, to get a allowance for doubtful accounts figure.
Risk Classification is difficult and the method can be inaccurate, because it’s hard to classify new customers. As well, customers in any risk category can change their behavior and start or stop paying their invoices.
Historical Percentage (Or Aging) Method
This is where a company will calculate the allowance for doubtful accounts based on defaults in the past. To do this, a company should go back five years, and figure out for every year the percentage of unpaid accounts. They can do this by looking at the total sales amounts for each year, and total unpaid invoices. An average can be created from that, in percentage form.
Now the company looks at total sales from this year. They multiply it by the percentage. The resulting figure is the new allowance for doubtful accounts number.
Pareto Analysis Method
This is also known as the “80/20” rule and is typically used by companies with a small
amount of large invoice balances.
The doubtful account balance is a result of a combination of the above two methods. The risk method is used for the larger clients (80%), and the historical method for the smaller clients (20%).
What Is the Journal Entry for Allowance for Doubtful Accounts?
Let’s use an example to show a journal entry for allowance for doubtful accounts.
Let’s say a company has calculated that $10,000 of its sales revenue are doubtful. This amount needs to be recorded in the company’s general ledger as both a debit and credit. It can be done as follows:
- Debit the expense as “Bad Debt Expense” account.
- Credit the allowance for “Doubtful Accounts”.
The doubtful accounts will be reflected on the company’s next balance sheet, as a separate line. It will offset the accounts receivable by $10,000.
The remaining amount from the bad debt expense account (the portion of the $10,000 that is never paid) will show up on a company’s income statement.
Does Allowance for Doubtful Accounts Get Closed?
Allowance for doubtful accounts do not get closed, in fact the balances carry forward to the next year. They are permanent accounts, like most accounts on a company’s balance sheet.
Bad debt expenses, reflected on a company’s income statement, are closed and reset.
Let’s give an example.
Peter’s Pool Company, based in Tampa, Florida, has estimated the balance allowance for doubtful accounts to be 14k. For the purposes of this example, let’s assume the 14k is 100% accurate and that none of that amount gets collected from the company’s clients.
Here’s what happens:
- On the balance sheet, the 14k is listed in assets as a deduction, directly below the accounts receivable figure. At end of the year, that 14k figure stays, and new allowances are added.
- On the income statement, the 14k is listed as a bad debt expense. This amount will affect the company’s net income. However, now that it has been accounted for, the 14k will be eliminated with the next income statement, and reset to $0.00.