What is Allowance for Doubtful Debts?
Allowance for doubtful accounts is an accounting estimate of accounts receivable that a business expects to be non-collectible from its customers.
The allowance for doubtful accounts is bad debt reserve funds created to cover those accounts receivable with a higher probability of default and converting to doubtful accounts.
What’s covered in the article
The doubtful accounts are due to customer defaults or other reasons resulting in unpaid customer invoices beyond the due date.
There are various methods to estimate bad debts. Still, the basic premise is to utilize historical data, trends, percentage of bad debts, assessment of the current economic situation, sectoral benchmarks, receivable aging report, and trade analysis.
Accounts receivable in a business arise due to credit sales. A higher level of doubtful accounts means higher credit risk, and financial statements could be reporting inflated revenues as they include all credit sales, too, due to the principles of the accrual accounting method.
The overall credit balance should consider the quality of outstanding accounts receivable, as those with a probability of default will result in an inaccurate picture of the business’s financial position.
Uses and Importance
A business’s income statement records all the revenues, including cash and credit sales. Regarding credit sales, there could be the risk of default for some percentage of unpaid invoices, which can be established by using two primary methods: the historical percentage method and the accounts receivable aging method.
Allowance for doubtful accounts makes provision to safeguard the business from the risk of doubtful accounts. It aims to ensure that financial accounts reflect the realistic picture of sales and revenue, impact on cash flow statement, and debtors on the balance sheet based on customer risk classification.
The state of doubtful accounts helps various stakeholders to know the company’s liquidity position soon. Some important uses of allowance for doubtful accounts are:
- Credit risk classification: Identifying the number of accounts receivable (AR) the company expects to turn into uncollectible accounts.
- Realistic financial statements: Ensuring accurate financial statements are produced for making informed decisions.
- Future cash flow estimation: Estimating the net realizable value of cash flow in the future from the total AR so that short-term capital can be raised to address cash flow requirements.
- Evaluating collection efficiency: When the amount of doubtful accounts is higher than the industry average, it exposes the inefficiency of the cash collection cycle.
- Measuring impact on working capital: Doubtful accounts negatively impact working capital management, which can severely hamper daily operations. Allowance for doubtful accounts acts as a cushion against credit defaults.
- Regulatory compliance: US GAAP and IFRS mandates the allowance for doubtful accounts to ensure a true and fair view of a company’s financial position and performance.
Establishing the Allowance for Doubtful Debts
The provision creating a bad debt reserve or allowance for doubtful accounts estimates the likely uncollectable payments from unpaid invoices.
When the sales method is based on accrual accounting, whenever the credit is extended to the customers, accounts receivable increase and reflect as an asset in the balance sheet. At the same time, it inflates the revenue in the income statement.
The default in outstanding accounts receivable is a futuristic event, which can be estimated in the following ways:
- US GAAP mandates that the allowance for doubtful accounts must be estimated. Provision should be created on the “estimated amount” during the same accounting period in which the sale is made.
- Under US GAAP (Generally Accepted Accounting Principles), the allowance for doubtful accounts can accumulate and carry forward across various accounting periods.
- US GAAP gives various factors for assessing the amount of allowance for doubtful accounts. The factors include historical data analysis, evaluating current economic trends, and the company’s expectation of credit risk. IFRS (International Financial Reporting Standards) consists of all of the methods given by US GAAP and requires specific identification for individual accounts.
Methods for calculating the Allowance for Doubtful Debts
Following are some of the methods to estimate the accounts receivable and calculate the allowance for doubtful accounts:
Percentage of Receivables Method
The percentage of receivables method, also known as the percentage of sales method, identifies bad debt accounts as a percentage of total sales or accounts receivable. The estimation is based on industry benchmarks and historical trends. The outcome of the estimate is used as the amount for the allowance for doubtful accounts provision.
Accounts Receivable Aging Method
The aging of receivables method is also known as the accounts receivable aging method or historical percentage method. The doubtful accounts are identified by classifying AR into aging categories. Then different percentages are applied as per the aging period reflecting the probability of the collection and creating the allowance for doubtful accounts.
For example, ARs due for more than 30 days have higher chances of turning to bad debts than those seven days old.
Direct Write-off Method
The direct write-off method only records the bad debt expense when the AR is declared bad debt. The bad debt expense account is created to reflect the actual loss and is posted directly to the income statement. The direct write-off method does not consider potential losses and can distort or misrepresent the financial picture.
Pareto Analysis Method
The Pareto analysis method is a statistical method where those customers are identified who contributes to the majority of debts and helps to focus the collection efforts on those customers to reduce the bad debt expenses.
Specific Identification Method
The specific identification method requires assessing each account receivable separately and calculating the portion of each account that might not be collectible based on prior experience and the present state of the economy and industry.
Recording Allowance for Doubtful Accounts
Allowance for doubtful accounts and bad debts expenses impact the company’s balance sheet and profit and loss statement.
Doubtful Accounts – Journal Entry
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Journal Entry for Creating Allowance for Doubtful Accounts |
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Date |
Particulars |
Debit |
Credit |
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Bad Debt Expense Account |
xxxx |
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To Allowance for Doubtful Debts |
xxxx |
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The bad debt expense account is an expense account on the income statement representing the estimated amount of accounts receivable the company does not expect to collect. The allowance for doubtful accounts, furthermore, is a contra-asset account on the balance sheet (a liability with a credit balance) that represents the estimated amount of accounts receivable that the company does not expect to collect over time.
The main difference between the bad debt expense account and the allowance for doubtful accounts is that the bad debt expense account represents the estimated losses for a specific period. In contrast, the allowance for doubtful accounts represents the estimated losses over a longer period.
The allowance for doubtful accounts calculation is based on the estimation of bad debt and is adjusted regularly.
Monitoring and adjusting the Allowance for Doubtful Debts
Journal Entry for Writing off Bad Debt
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Date |
Allowance for Doubtful Accounts Dr. |
xxxx |
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To Accounts Receivable |
xxxx |
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(Writing-off the bad debt account) |
Journal Entry for Recovery of Bad Debt (Adjusting Entry)
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Date |
Cash Dr. |
xxxx |
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To Accounts Receivable |
xxxx |
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(Recording the receipt of cash) |
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Accounts Receivable Dr. |
xxxx |
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To Allowance for Doubtful Debts |
xxxx |
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(Adjusting entry to reverse the write-off) |
Example of Journal Entries related to allowance for doubtful accounts
Example: Company A has given the following data:
- On 10th April, the accounts receivable had a debit balance of $ 75,000
- On 21st May, the accountant estimated that the bad debts could amount to $ 10,000
- On 17th July, a customer having dues of $ 2000 declared bankruptcy.
- On 11th August, a customer who declared bankruptcy earlier paid.
- On 2nd December, another customer paid $ 1000, which is not a part of bad debt.
Pass the required journal entries related to the above facts.
Solution
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Journal Ledger of Company A for the Year 2023 |
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Date |
Particulars |
Debit ($) |
Credit ($) |
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May 21 |
Bad Debt Expense Dr. |
10,000 |
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To Allowance for Doubtful Accounts |
10,000 |
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(Estimating the default payments) |
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Note: Bad Debt Expense (debit balance) will be posted to the company’s income statement as net loss, while the Allowance for Doubtful Accounts will be posted to Balance Sheet as a liability, The net realizable accounts receivable on the balance sheet will be $ 65,000 as on 31st May 2023. |
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July 17 |
Allowance for Doubtful Accounts Dr. |
2000 |
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To Accounts Receivable |
2000 |
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(Writing-off the bad debt account) |
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Aug 11 |
Cash Dr. |
2000 |
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To Accounts Receivable |
2000 |
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(Recording the receipt of cash) |
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Accounts Receivable Dr. |
2000 |
||
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To Allowance for Doubtful Debts |
2000 |
||
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(Adjusting entry to reverse the write-off) |
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Dec 2 |
Cash Account Dr. |
1000 |
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To Account Receivable |
1000 |
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(Being cash received from a credit sales) |
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Conclusion
Allowance for doubtful accounts is important to account for the credit risk arising from non-recoverable unpaid invoices. Small businesses need to build a cushion of the provision created for the allowance for doubtful accounts so that the working capital requirements are not hampered, and more accurate financial statements are generated.
Accounting and recording the transactions related to the allowance for doubtful accounts is important for decision-making and regulatory compliance. Visit Akounto’s Blog and learn about important accounting concepts crucial for your business.
