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Allowance for Doubtful Accounts: Definition – Explanation – Examples

What Is an Allowance for Doubtful Accounts?

Allowance for Doubtful AccountsAn allowance for doubtful accounts is a contra asset account used to reduce receivables in an amount estimated by management to be uncollectible.  It is a contra asset account because it decreases the amount of an asset, in this case, accounts receivable. The allowance is also known as a bad debt reserve.  It predicts the percentage of receivables that are likely to be uncollectible. Customers’ actual payment behavior, however, may deviate significantly from the estimate. If real experience varies, management can modify its estimating process to get the reserve closer to actual results.

In accrual-based accounting, the provision for doubtful accounts is recorded at the same time as the sale.  This enhances the accuracy of financial reports because an expected bad debt charge is accurately matched to the relevant transaction.  As a result, it offers a more realistic picture of income and expenses for a given time period. This accounting approach helps to avoid huge fluctuations in operational results.  For example, when large uncollectible accounts are suddenly written off as bad debt expenditures.

Allowance for Doubtful Accounts – A Closer Look

Extending credit terms to customers comes with the inherent risk of not getting paid.  This is regardless of the company’s credit collection rules and procedures. As a result, a corporation is obligated to recognize this risk.  They do this by establishing an allowance for doubtful accounts and offsetting bad debt charges. As a result, costs linked to the sale are recognized in the same accounting period that income is collected. This is an important feature in accrual accounting and generally accepted accounting principles (GAAP). The provision for questionable accounts also assists businesses in more properly estimating the true worth of their account receivables.

According to GAAP, the allowance for doubtful accounts is generated in the same accounting period as the original sale.  However, an organization cannot predict with certainty which specific receivables will be paid and which will default. As a result, the allowance might be based on an educated guess or estimated value. The allowance can build throughout accounting periods and be modified based on the actual account balance.

Purpose of the Allowance

Consider a corporation that has 100 clients that buy on credit and the total amount due is $2,500,000. This amount will be recorded as accounts receivable on the balance sheet. The allowance for doubtful accounts is used to predict how many customers will not pay the entire amount owed. Rather than waiting to see how payments turn out, the corporation will make an estimate based on their experience.  This estimate is the figure used to debit a bad debt expense and credit allowance for questionable accounts. It is listed as a deduction immediately below the accounts receivable line item on the company’s balance sheet.

Recording the Allowance for Doubtful Accounts

There are four basic approaches for predicting the monetary amount of accounts receivable that are not expected to be collected.

Percentage of Sales Method

This method applies a fixed percentage to the period’s total dollar sales. For example, a corporation may anticipate that 5% of net sales will be non-collectible based on recent experience. If the total net sales for the period are $200,000, the corporation makes a $10,000 allowance for doubtful accounts.  At the same time, accounting also reports $10,000 as a bad debt expense. If net sales are $150,000 in the following accounting period, an additional $7,500 is recorded in the allowance for doubtful accounts.  Additionally, another $7,500 is recorded as a bad debt expense in the following period. After these two periods, the total sum in the allowance for doubtful accounts is $17,500.

Historical Percentage of Credit Sales 

It makes sense to estimate an allowance for doubtful accounts using past collection data. Because cash transactions have a 100% collection rate, some businesses prefer to focus only on credit sales. Others look at the overall AR gathered as a proportion of the total AR collected. If a business is mostly based on credit sales, either number is appropriate. For companies with a high volume of cash sales, calculating as a percentage of accounts receivable collected may provide a greater margin of safety. However, this figure may be overly cautious, thereby lowering AR levels unrealistically.

Customer Risk Classification

In the customer risk categorization approach, a default risk proportion is applied to each client. You may study a customer’s previous payment collection data and assess the proportion of invoices on which they tend to default. This method works well with a limited and steady client base that follows comparable credit cycles. With larger consumer bases, applying one of the other solutions may be easier to apply.

Accounts Receivable Aging Method

The aging technique is the second approach for assessing the allowance for dubious accounts. All outstanding accounts receivable are divided into groups based on their age.  Then, percentages are applied to each group based on corporate experience. The anticipated uncollectible amount is the sum of the findings.

Example

For example, consider a corporation with $100,000 in accounts receivable that is less than 30 days old and $90,000 in accounts receivable that is more than 30 days old. According to corporate experience, 2% of accounts receivable less than 30 days old will be uncollectible, while 4% of accounts receivable at least 30 days old would be uncollectible. As a result, the corporation will record a $6,500 allowance (($100,000 x 2% = $2,000) + ($90,000 x 4% = $4,500)).

Assume the allowance for uncollectible accounts shows a credit balance of $600 before adjustment. In that case, you will make the following adjusting entry:  $6,500 – $600 = $5,900 (adjusting entry).

Allowance for Doubtful Accounts versus Bad Debt Expense

A bad debt expense and an allowance for doubtful accounts represent the same issue in business.  However, they are treated very differently in the accounting world.

  • Allowance for doubtful accounts is a balance-sheet account that is recorded as a contra asset. On financial statements, it has a credit balance. It is recognized as an estimate of accounts receivable that are expected to go uncollected.
  • Bad debt expense is an income statement account and carries a debit balance. It reflects the amount of bad debt incurred by the firm during the current accounting period. In other words, it is a record of receivables that went unpaid within a fiscal reporting period. Where AFDA is a guess, BDE tracks the real impact of uncollected receivables.

Up Next: What Is Free Cash Flow Yield (FCFY)?

Free Cash Flow YieldThe free cash flow yield (FCFY) is a financial solvency metric that compares a company’s predicted free cash flow per share to its market value per share. The ratio is computed by dividing free cash flow per share by the current share price. As an analytical tool, free cash flow (FCF) is valuable for determining a company’s operating potential. Businesses with robust cash flows are generally financially sound.  However, firms with weak FCFs may be unable to satisfy their short-term obligations.

By comparing free cash flows to market value, the Free Cash Flow Yield gives additional insight into a firm’s operating strength. A low FCFY implies that investors are injecting more money into the company than the profits it earns. Financial analysts examine FCF yield in conjunction with a firm’s capital expenditures.  This extra step helps to determine whether possibly poor FCFs can be justified by fixed asset investments.

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