Suppose a company generated $1 million of credit sales in Year 1 but projects that 5% of those sales are very likely to be uncollectible based on historical experience. Otherwise, it could be misleading to investors who might falsely assume the entire A/R balance recorded will eventually be received in cash (i.e. bad debt expense acts as a “cushion” for losses). The actual payment behavior of customers, or lack thereof, can differ from management estimates, but management’s predictions should improve over time as more data is collected. The allowance for doubtful accounts is management’s objective estimate of their company’s receivables that are unlikely to be paid by customers. The Allowance for Doubtful Accounts is a contra-asset account that estimates the future losses incurred from uncollectible accounts receivable (A/R).
If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400. Since it is an estimate of the bad debt expense a company expects to incur, days sales outstanding (DSO) also plays a vital role in its calculation.
Allowance for Uncollectible Accounts Definition
In the example above, we estimated an arbitrary number for the https://accounting-services.net/5-4-direct-versus-indirect-method/. There are two primary methods for estimating the amount of accounts receivable that are not expected to be converted into cash. For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and 4% of those accounts receivable at least 30 days old will be uncollectible.
In addition, this accounting process prevents the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses. And, having a lot of bad debts drives down the amount of revenue your business should have. By predicting the amount of accounts receivables customers won’t pay, you can anticipate your losses from bad debts. The allowance for doubtful accounts is a general ledger account that is used to estimate the amount of accounts receivable that will not be collected.
What Is an Allowance for Doubtful Accounts (ADA)?
Businesses that offer trade credit to their customers keep an Allowance for Doubtful Accounts on their balance sheet. It is an estimate of the amount of accounts receivable (AR) that a business expects to become bad debt. Basically, your bad debt is the money you thought you would receive but didn’t.
Self-insuring by using allowances for doubtful accountsbad debt reserves may come without a direct cost, but it offers limited benefits in the event of a catastrophic loss. Remember, unpaid invoices weaken your cash flow and those additional costs will add up quickly. Utilizing an allowance for doubtful accounts if a customer doesn’t pay also requires more internal resources to manage the risk.
Allowance for Doubtful Accounts: Calculation
To establish an adequate allowance for doubtful accounts, a company must calculate its bad debt percentage. To make that calculation, divide the amount of bad debt by the company’s total accounts receivable for a period of time and then multiply that number by 100. The company can recover the account by reversing the entry above to reinstate the accounts receivable balance and the corresponding allowance for doubtful account balance. Then, the company will record a debit to cash and credit to accounts receivable when the payment is collected.
What is the allowance for doubtful accounts on a balance sheet?
The allowance for doubtful accounts is a reduction of the total amount of accounts receivable appearing on a company's balance sheet, and is listed as a deduction immediately below the accounts receivable line item. This deduction is classified as a contra asset account.