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 receivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. 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 journalAccounting JournalAccounting journal, often known as the book of original entry, is first used to record the company's accounting record whenever a financial transaction occurs. It's difficult to comprehend, yet it's crucial in business operations and accounting. entries for the allowance for doubtful accounts.
We will take an example of an accrual accountingAccrual AccountingAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. basis.
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, based on accrual accounting, we need to pass an entry stating that there can be bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation. shortly.
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 accountingThe Rule Of AccountingAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. , if an expense increases, we debit that account; that’s why bad debt is debited. And similarly, 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 salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. 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 agencyCollection AgencyA collection agency refers to a firm engaged in the recovery of the default loans or dues from the borrowers on behalf of the lenders or creditors. A loan provider or creditor outsources its debt-collection function to such a third party to reduce bad debts. 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 entryReverse The Previous EntryReversing entries refer to those journal entries passed in the current accounting period to offset the entries for outstanding expenses and accrued income recorded in the immediately preceding accounting period. 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 statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. 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 companySolvency, The CompanySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease. assigns them a score. The customers who have 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 suitable 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 the Pareto principle twice. Extending the above example, if we use 20% of the previous 20% (i.e., 4%), we will 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 balanceAccount BalanceAccount Balance is the amount of money in a person's financial account, such as a savings or checking account, at any given time. Furthermore, it can refer to the total amount of money owed to a third party, such as a utility company, credit card company, mortgage banker, or other similar lender or creditor. 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 article has been a guide to what is an allowance for doubtful accounts and its definition. Here we explain the concept of
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 –