What is an allowance for doubtful accounts?
An allowance for doubtful accounts is a method used in accounting to record the number of accounts receivable that a business considers uncollectible.
Put in other words, it is a technique that allows the management of a business to have a more realistic and accurate view of the amount that will actually be paid by the debtors (customers who bought goods on credit) of the business.
What are doubtful accounts?
Doubtful accounts refer to the portion of accounts receivable of a business that the management doubts whether it will be collected in the future, expecting that it might become a bad debt eventually.
Simply put, doubtful accounts represent the receivables that are doubtful to be collected.
Purpose of the allowance for doubtful accounts
The risk that customers will default on their debt owed to a business is always present.
Hence, a business is required to realise the risk in advance, offsetting the bad debt expense by making use of an allowance for doubtful accounts.
The allowance enables a business to determine the value of its accounts receivable more accurately.
In addition, the allowance helps investors and creditors to see what the realistic expectation of a business’s management, regarding collecting outstanding debt from its debtors, is.
Recording and reporting the allowance for doubtful accounts in accounting
Typically, at the end of an accounting cycle, such as a quarter or financial year, management estimates the amount of uncollectible debt in order to record the transactions concerning the doubtful receivables of the business.
Generally accepted accounting principles (GAAP) require that the allowance must be set up in the same accounting period as the sale of the goods, referred to as the matching principle.
Example of the recording of the allowance for doubtful accounts
Business We Will Survive estimates that R50 000 of its receivable accounts are doubtful. The amount of R50 000 will be recorded in the accounting system via the following journal entries:
- Debit the R50 000 in the ‘Bad Debt Expense Account’
- Credit the R50 000 in the account, called ‘Allowance for Doubtful Accounts’
The bad debt expense account will be reported on We Will Survive’s income statement as an expense, reducing its gross profit. Bad debt expenses are closed at the end of the accounting cycle and not carried forward to the next accounting cycle.
The allowance account is reported on the balance sheet, listed as a contra asset account, directly below the accounts receivable in the current assets section. Hence, reducing the outstanding receivable accounts reported on the balance sheet. The reduced balance of the receivables is referred to as the net realisable value of the receivables.
(In accounting, a contra asset account is an asset account with a credit (negative) balance. Contrarily, normal assets accounts have a debit balance.)
An allowance for doubtful accounts is a permanent account, implying it does not get closed at the end of an accounting cycle but is carried forward to the next accounting cycle, such as a financial year.
Methods to estimate the amount of an allowance for doubtful accounts
Basically, there are two methods to estimate the number of receivables that are expected not to be collected.
- Percentage of credit sales method
When using the credit sales method, a business applies a flat rate (percentage) to the total amount of sales for a certain accounting period.
Typically, the flat rate is based on the previous experiences of the business and industry reports regarding bad debts.
For instance, let us say, previous experiences and industry reports prove that about 4% of net sales are not collectible. If the total net sales of the accounting period are R500 000, the business will create an allowance for doubtful accounts for R20 000 (4% x R500 000).
If the next accounting period delivers sales of R550 000, an additional amount of R2 000 (4% x R50 000) will be recorded in the allowance account. At the end of this period, the bad debt expense account will have a debit balance of R22 000 and the allowance for doubtful accounts will reflect a credit balance of R22 000 (R20 000 + R2 000).
- Accounts receivable aging method
The accounts receivable aging method, commonly referred to as the aging method, is a method in which all outstanding accounts receivable are grouped by date ranges. For instance, 0 – 30 days, 31 – 60 days, 61 – 90 days, 91 – 120 days, and 121 – 150 days. Subsequently, specific percentages are applied to each date range.
For example, a selection from the accounts receivable of company Try Again indicates the following amounts in the different date ranges:
- 0 – 30 days: R80 000
- 31 – 60 days: R55 000
- 61 – 90 days: R45 000
- 91 – 120 days: R25 000
- 121 – 150 days: R10 000
Based on previous experience, the percentages for estimated bad debt are as follows:
- 0 – 30 days: 1%
- 31 – 60 days: 15%
- 61 – 90 days: 25%
- 91 – 120 days: 50%
- 121 – 150 days: 60%
Thus, Try Again will record an allowance of R38 800, calculated as follows:
(R80 000 x 1%) + (R55 000 x 15%) + (R45 000 x 25%) + (R25 000 x 50%) + (R10 000 x 60%)
= R800 + R8 250 + R11 250 + R12 500 + R6 000
= R38 800
If the following accounting period’s estimation amounts to R45 000, only R6 200 (R45 000 – R38 800) will be added to the balance of the allowance account.
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