What's the likelihood of your customers repaying their debts?
Have you been thinking of laying your hands on ways to calculate the allowances for those amounts that may never be paid to you?
Including a provision for doubtful accounts can protect businesses from unforeseen losses by taking into account the possibility that some customers might fail to pay.
The purpose of this article is to clarify the meaning of the allowance for doubtful account, along with the associated topics:
- What is the Allowance for Doubtful Accounts?
- Who uses allowance for doubtful accounts?
- How to calculate the allowance for doubtful accounts?
- What are examples of allowance for doubtful accounts?
- What is the Entry for Doubtful Accounts?
What is the Allowance for Doubtful Accounts?
The allowance for doubtful accounts indicates the allowance that lowers the accounts receivables on the balance sheet of an organization.
It is a contra asset account. Contra asset accounts are accounts that have either a zero balance or a credit balance indicating the true value of receivables. This type of an account reduces the total amount of accounts receivable on a balance sheet to more accurately represent what money a business can collect.
Who uses Allowance for Doubtful Accounts?
Businesses that offer their goods or services on credit to their clients initiate and set up doubtful accounts to ensure that accounts receivables are accurate in the balance sheet. Accountants and managers also make use of the doubtful accounts to make a note of the payments that are still in their collectibles’ list.
Establishing doubtful accounts helps the companies to prevent inaccuracies in the financial statements. The right time to record the entries for this kind of account varies from business to business and their reporting cycles. However, the recording and reporting periods must be the same.
Reporting the allowances for the doubtful accounts at the time of the sale greatly enhances the validity of your financial statements. It not only provides a more accurate viewing of the reports but also improves performance outcomes drastically.
How to Calculate the Allowance for Doubtful Accounts?
The most commonly accepted methods to calculate the allowance for the doubtful accounts are as follows:
Risk Classification
As the name suggests, you classify the risk associated with each of the customers in terms of their likelihood of paying off the debts. The higher the risk, the less likely the customer is to pay the remaining amount. You can have various classes or classifications ranging from high, low, to medium.
Historical Percentage
The company’s past experiences play a role here. Based on the previous exchanges, a company is better positioned to make an estimate of the allowances against the doubtful accounts. They can prepare themselves for the accounts receivables that previously turned into bad debts. In the future, they would be able to make better predictions and cut down the risks associated with it.
Pareto Analysis
In this method, businesses can scan through their accounts receivable that form over 80% of the balance, and shortlist the customers that are most likely to default. This method is better applicable to larger accounts, whereas for the smaller accounts, the historical percentage method could be utilized.
Read Details of Pareto Analysis: Pareto Analysis: How and When to Use?
Percentage of Sales
In the percentage sales method, the company assigns a flat percentage to estimate the amount for the accounts receivable for the given accounting period. We can understand this better with the help of an example.
If a company has experienced bad debt of 2% in the past, it will expect a similar percentage of bad debt in this period as well. If its total sales are worth $100,000, the company tends to create an allowance for the doubtful accounts for $2,000 based on its previous experience. Also, it will also report $3,000 as an expenditure towards bad debt.
Comparison
This method considers and compares the accounts receivable that are already past due are unlikely to be collected. Although this method doesn't provide as much information as others, it can still be of great benefit to your business. Consider reevaluating your accounts if the predicted allowance is less than the overdue accounts.
Accounts Receivable Aging
Accounts Receivable Aging is another method for estimating the allowance for doubtful accounts. In this method, you are required to group all outstanding receivables by age and, then, allocate different percentages to each group. The total would then reflect the amount of unpaid receivables. Budgeting at this point would be easier.
What are Examples of Allowance for Doubtful Accounts?
Let’s look at some examples of the allowance for doubtful accounts:
Accounts receivable aging method example:
Let’s assume a company finds out that 10% of its accounts receivables are over 60 days due and only 5% are due within 60 days. These remain as collectibles. The amounts respectively for over 60 days and within 60 days are $5,000 and $10,000.
Therefore, the company assesses the allowance by multiplying the amount of accounts receivable by the corresponding percentage of aging period. Further, the two are added. Here is how it goes:
$5,000 x 0.10 = 500
$10,000 x 0.05 = 500
$500 + $500 = $1,000
As a result, the company estimates an allowance of $1,000 for the doubtful accounts.
Historical percentage method example:
A company realizes through its prior experience and historical records that about 3% of its sale amount remains collectible. The current account receivable is $25,000. Therefore, they make an estimate of the allowance by multiplying the percentage and the accounts receivables.
$25,000 x .03 = $750
Consequently, the company estimates its allowances as $750 against the doubtful accounts.
What is the Journal Entry for Doubtful Accounts?
The allowance of doubtful accounts is a journal entry created for monitoring bad debts and following up on payments owed. As part of the journal entry, bad debt expenses are debited and the expected payment is credited.
Businesses credit their account receivable and debit the allowance for doubtful accounts when the debt becomes bad debt. Sometimes, customers pay off bad debt. If this occurs, the balance sheet manager debits the accounts receivable to reverse the account.
Where to place Allowance for doubtful accounts in a balance sheet
Companies place the allowance of doubtful accounts under assets in their balance sheets. This item is positioned below accounts receivable, indicating that this is the amount the company is expecting to receive. An allowance for doubtful accounts is a deduction that allows the company to keep track of bad debt.
The balance sheet of a company A might include an allowance for doubtful accounts as follows:
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Key Takeaways
Here are the highlights of the article:
- The allowance for doubtful accounts indicates the allowance that lowers the accounts receivables on the balance sheet of an organization.
- It is a contra asset account.
- Businesses that offer their goods or services on credit to their clients initiate and set up doubtful accounts to ensure that accounts receivables are accurate in the balance sheet.
- Establishing doubtful accounts helps the companies to prevent inaccuracies in the financial statements.
- Risk classification, historical percentage, pareto analysis, percentage of sales, comparison, and accounts receivable aging are the methods to calculate the allowances for the doubtful accounts.
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