What is Allowance for doubtful accounts?
Allowance for doubtful accounts primarily means creating an allowance for the estimated part of the accounts that may be uncollectible and may become bad debt and is shown as a contra asset account that reduces the gross receivables on the balance sheet to reflect the net amount that is expected to be paid.
While thinking about what would await, in the near future, a business must be pragmatic. It has to think in terms of how much they would be paid and how they would never receive it.
For example, if ABC Company sells raw materials for around $100,000 on credit, do you think the whole amount of the company would be paid off? The reality is maybe just 90% of the whole amount, i.e. $90,000 would be paid off in full and the rest would be considered as bad debts.
If a company starts thinking about the bad debts way too late, it wouldn’t be possible for the company to prepare for it immediately. That’s why an estimated figure for what may not be received is decided in advance.
Allowance for Doubtful Accounts Example
Let us see the balance sheet of Colgate.
source: Colgate SEC Filings
We note that accounts receivables are reported net of allowances for doubtful accounts. Colgate reports allowances for doubtful accounts as $54 million and $67 million in 2014 and 2013, respectively.
In this section, we will take a simple example and then illustrate how you should pass accounting journal entries for the allowance for doubtful accounts.
We will take an example of accrual basis of accounting.
Journal Entries # 1
Let’s say that Rough Jeans Ltd. has estimated that the allowance for estimated debts would be around $200,000 for the year. So, on the basis of accrual accounting, we need to pass an entry stating that there can be bad debts in near future.
And here’s the first entry that we would pass –
Bad Debts A/C………………………Dr $200,000 –
To Allowance for Doubtful accounts Debts A/C – $200,000
In the first entry, we debited bad debt account because bad debt is an expense. As per the rule of accounting, if an expense increases, we debit that account; that’s why bad debt is debited. And in a similar manner, we follow the same accounting rule here by crediting the allowance for doubtful debts account. Since they are provisioned and are used as counter-asset, we will credit it.
If the credit sales are $10 million, then by recording this entry we’re offsetting bad debt from the credit sales already.
Journal Entries # 2
Now, let’s say that the company has got the actual figure and it has seen that $120,000 is bad debt. So, what would be the new entry in this case?
We will pass the following entry –
Allowance for doubtful accounts debts A/C………. Dr $120,000 –
To Accounts Receivables A/C – $120,000
In this entry, we are debiting allowance for doubtful debts because by this amount the counter-asset has been reduced and we’re crediting accounts receivables to reduce the outstanding accounts receivables by $120,000.
Journal Entries # 3
Now let’s say that the company has asked a collection agency to try out to recover the bad debts. And they could successfully collect $40,000. So we need to pass another entry to recognize the collection.
We will just reverse the previous entry as now there are chances of getting $40,000 as outstanding accounts receivables.
Accounts Receivables A/C…………Dr $40,000 –
To Allowance for doubtful accounts debts A/C – $40,000
Effect on Income Statement and Balance Sheet
- The first journal entry above would affect the income statement where we need to pass the entry of the bad debt and also for the allowance for doubtful debts account.
- And the second and third journal entries will only affect the balance sheet where we will first deduct the amount of provision from the accounts receivables and if any amount is collected, we will add that amount back.
How would one estimate the allowance for doubtful accounts?
So, here are the three methods that organizations use to estimate the allowance for doubtful debts?
- Risk Score: This is one of the common methods companies use. They look at each of their customers. Then as per their solvency, the company assigns them a score. The customers who have the higher scores are added and then the company gets an estimate of how much allowance a company needs to keep for possible bad debts. This method may not be the most accurate one, but it works for most of the companies.
- Historical percentage: This is another method that organizations use a lot. By using this method, an organization looks at the past results. They look at the past results and find out what percentage of bad debts happened in the past year. They go with the same percentage for the present year as well. It may sound a simple act, but it’s not a good method if you’re looking for accuracy.
- Pareto Analysis: This is by far the best method to use while estimating the allowance for bad debts. Italian economist, Pareto said that you would get 80% of results from only 20% of your activity. By using the same principle the organizations calculate their allowance. Here’s how it works. If the total credit sales is of $100,000, then the allowance for doubtful debts would be (as per Pareto principle) = ($100,000 *20%) = $20,000. But this method can be a broad estimation. To become more accurate about how much provisions we should create, we can use double Pareto. We need to simply use Pareto principle twice. Extending the above example, if we use the 20% of the previous 20% (i.e. 4%), we would get an accurate picture. It means the allowance for doubtful debts account would be $4000 to be precise.
One way to figure out whether you have estimated sufficient balance for the allowance for doubtful debts is to look at the account balance of the doubtful accounts. By looking at the doubtful accounting balance and comparing the whole account balances of the doubtful accounts with the full credit amount, you would get a solid percentage. And you would also understand whether the allowance you estimated is sufficient or not.
Allowance for Doubtful Accounts Video
This has been a guide to what is an allowance for doubtful accounts and its definition. Here we explain the concept the help of examples, journal entries and how it affects the income statement and balance sheet. You may also have a look at the following recommended articles to learn more about accounting –