- Learn Basic Accounting in Less than 1 Hour!
- Accounting Basics
- What are Accounting Principles
- Accounting Cycle
- Accrual Accounting Basis
- Cash Basis Accounting
- Matching Principle of Accounting
- Conservatism Principle of Accounting
- Cash Accounting
- What are Accounting Policies?
- Accounting Estimates
- Mark to Market Accounting
- Cash Accounting vs Accrual Accounting
- Operating Cycle
- Fiscal Year
- Fiscal Year vs Calendar Year | Top Differences | Examples |
- Financial Reporting
- Financial Statements
- Interim Financial Statements
- Consolidated Financial Statement
- Audited Financial Statements
- Accounting Scandals
- Quality of Earnings
- IFRS vs US GAAP
- IFRS vs Indian GAAP
- Accounting for Fair Value Hedges
- Debit vs Credit in Accounting
- Double Entry Accounting System
- Journal in Accounting
- Ledger in Accounting
- Journal vs Ledger
- What is Trial Balance ? | Examples | Steps | Prepare | Errors
- Reconciliation of Books | Types, Best Practices | Useful Tips
- Petty Cash | Meaning | Template | Accounting | Example
- Debit Note | Debit Notes Accounting & its Top Characteristics
- Credit Note
- Debit Note vs Credit Note | Top 7 Differences (Infographics)
- Balance Sheet
- Balance Sheet
- Accounting Equation
- Assets vs Liabilities | Top 9 Differences (with Infographics)
- Trial Balance vs Balance Sheet | Top 10 Differences You Must Know!
- Balance Sheet vs Consolidated Balance Sheet
- Bank vs Company Balance Sheet
- Commitments and Contingencies
- Management Discussion & Analysis
- Revenue Reserve vs Capital Reserve | Top 7 Differences
- Revenue Reserve
- Capital Reserve
- Capital Receipts vs Revenue Receipts | Top 8 Differences
- Capital Lease vs Operating Lease | Top Differences You Must Know!
- Debt vs Equity Financing | Advantages | Disadvantages | Example
- Internal vs External Financing | Top 7 Differences (Infographics)
- Available for Sale for securities
- Held to Maturity to securities
- Cash and Cash Equivalents | Examples, List & Top Differences
- Cash Equivalents
- Restricted Cash
- 3 Types of Inventory | Raw Material | WIP | Finished Goods
- Current Assets
- FIFO vs LIFO
- First In First Out (FIFO)
- Last in First Out (LIFO)
- LIFO Reserve
- Non-Current Assets
- Accounts Receivables? | Definition, Accounting Examples
- Accounts Receivables Factoring
- Allowance for Doubtful Accounts
- Accrued Revenue
- Liquid Assets
- Quick Assets
- Marketable Securities on the Balance Sheet | Top Examples
- Trading Securities in Balance Sheet
- Prepaid Expenses
- Tangible vs Intangible Assets
- Net Tangible Assets | Calculate Net Tangible Assets Per Share
- Tangible Assets
- Capital Expenditure (Capex)
- Salvage Value
- Residual Value
- Fixed Capital vs Working Capital | Top 8 Differences (Infographics)
- Impariment of Assets
- Negative Goodwill
- Accounts Payable | Days Payable Outstanding | Formula |
- Current Liabilities | List of Current Liabilities on Balance Sheet
- Accrued Liabilities
- Notes Payable
- Revolving Credit Facilities
- Bonds Payable Accounting
- Bad Debt Reserve Allowance
- Deferred Expenses
- Unearned Revenue (Sales)
- Deferred Revenue (Income)
- Current Portion of Long-Term Debt (CPLTD) | Balance Sheet
- Long-Term Debt in Balance Sheet
- Financial Liabilities | Definition, Types, Ratios, Examples
- Long-Term Liabilities
- Accounts Receivable vs Accounts Payable
- Minority Interest
- Accounting for Convertibles
- Accounting for Derivatives
- Financial Lease vs Operating Lease
- Off balance Sheet Financing
- Finance vs Lease
- Shareholders Equity
- Shareholders Equity Statement
- Negative Shareholders Equity
- Par Value of Stock
- Share Capital
- Outstanding Shares (Definition, Formula) | Stocks Outstanding
- Additional Paid-in Capital on Balance Sheet
- Retained Earnings (Formula, Examples) | How to Calculate?
- How to Calculate Net Worth of a Company | Formula | Top Examples
- Owners Equity
- Preferred Shares
- Weighted average Shares average outstanding
- Share Buyback
- Accelerated Share Repurchase
- Restricted Stocks Units (RSUs)
- Contingent Shares
- Stock Splits Share
- Treasury Stock Shares
- Dilutive Securities
- Anti Dilutive Securities
- Stock Dividend
- Cash Dividend
- Preferred Dividends
- Homemade Dividends
- Ex dividend date
- Date of Record of dividends
- Cost of preferred Stock
- Common Stock vs Preferred Stock | Top 8 Differences You Must Know
- Stocks Vs Shares
- Stock Options Vs RSU
- Shareholder Equity vs Net Worth | Top 5 Differences You Must Know!
- Stock vs Option
- Stock vs Mutual Funds
- Income Statement
- Income Statement | Top Examples | Template | Format | Analysis
- Cost of Goods Sold
- Direct Costs
- Indirect Costs
- Non Recurring Items
- EBIT vs EBITDA | Top Differences | Examples | Calculation
- Depreciation – Formula | Types | Most Comprehensive Guide
- EBITDA vs Operating Income
- Straight Line Depreciation Method
- Sum of Year Digits Method of Depreciation
- Declining Balance Method of Depreciation
- Amortization of Intangible Assets
- Unrealized Gains (Losses)
- Non Cash Expense
- Share based compensation
- Restructuring Cost
- Extraordinary Items
- Interest Income
- Double Taxation
- Net Loss
- Net Operating Loss (NOL)
- Tax Shield
- Sundry Expenses
- Interest vs Dividend | Top 9 Differences (with Infographics)
- EBITDA vs Net Income
- EBIT vs Net Income
- EBIT vs Operating Income
- Cost vs Expense
- Accounting Profit vs Economic Profit
- Income Tax vs Payroll Tax
- Tax credits vs Tax deductions
- Gross Income vs Net Income
- Profit vs Revenue
- Revenue vs Earnings
- Revenue vs Income
- Profit vs Income
- Revenue vs Sales
- Capitalization vs Expensing
- Income Statement vs Balance Sheet | Top 5 Differences You Must Know!
- Statement of Comprehensive Income | Items | Colgate Example
- FOB Destination
- Explicit Cost
- Implicit Cost
- Direct cost vs Indirect Cost
- Fixed cost vs Variable cost
- Nopat vs Net Income
- Marginal Costing vs Absorption Costing
- Cash Flow Statement
- Cash flow from Operations | Formula, Calculations & Examples
- Cash Flow from Investing Activities (Formula & Top Examples)
- Cash Flow From Financing Activities | Formula & Calculations
- Cash Flow Analysis
- Fund Flow Statement
- Direct vs Indirect Cash Flow Methods
- Cash flow vs Net Income | Key Differences & Top Examples
- Cash Flow vs Fund Flow | Top 8 Differences (with Infographics)
- Accounting Careers
- Accounting Interview Questions
- Financial Accounting Careers
- Top Accounting Firms
- Big Four Accounting Firms
- Forensic Accounting
- Cost Accounting
- Financial Accounting
- Accounting vs Engineering
- Finance vs Accounting
- Bookkeeping vs Accounting
- Accounting vs Auditing
- Bookkeepers vs Accountants
- Accounting vs Financial Management
- Cost Accounting vs Financial Accounting
- Cost Accounting vs Management Accounting
- Financial Accounting vs Management Accounting
- Public vs Private Accounting
- Accounting vs CPA
- Controller vs Comptroller
- Accounting Firms in Australia
- Accounting Firms in Canada
- Top Accounting Firms in US
- Accounting Books
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 will become bad debt.
While thinking about what would await, in 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.
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. And we call it the allowance for doubtful accounts.
Allowance for Doubtful Accounts Example
As an 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.
WallStreetMojo Free Accounting Course
You will Learn Basics of Accounting in Just 1 Hour, Guaranteed!
* Please provide your correct email id. Login details for this Free course will be emailed to you
Allowance for Doubtful Accounts – Journal Entries
Now as you figured out a way to estimate the allowance for doubtful debts account, it’s time to make the entry.
But how would you do so? 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.
Allowance for Doubtful Accounts – 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 the allowance for doubtful debts are provisioned and is 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.
Allowance for Doubtful Accounts – 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.
Allowance for Doubtful Accounts – 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
Allowance for Doubtful Accounts – 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?
This is the most obvious question. How would one estimate the allowance for doubtful debts? It isn’t easy and it isn’t accurate most of the time. But it doesn’t need to hit the bull’s eye. It has to be within the range.
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 for doubtful debts. 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.
This has been a guide to what is an allowance for doubtful accounts. Here we explain the concept with the help of allowance for doubtful accounts examples, journal entries and how it affects income statement and balance sheet. You may also have a look at the following recommended articles to learn more about accounting –