Allowance for Doubtful Accounts
The allowance for doubtful accounts is a contra-asset on the balance sheet that represents management’s estimate of accounts receivable (AR) unlikely to be collected. It lets companies recognize expected bad debts in the same period as the related sales, supporting accurate profit measurement and compliance with the matching principle.
Key takeaways
- The allowance provides a more realistic AR balance by estimating future write-offs.
- Bad debt expense is recorded in the period of the sale; actual write-offs reduce both AR and the allowance.
- Common estimation methods include percentage of sales, AR aging, customer-risk segmentation, and specific identification.
- Sudden changes in the allowance can signal shifts in customer credit quality or possible manipulation of earnings.
Methods to estimate the allowance
Choose a method based on the business’s customer mix, historical data, and how receivables age.
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- Percentage of Sales
- Apply a historical bad-debt percentage to credit sales.
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Example: If historical uncollectibles are 2% and credit sales are $500,000, record $10,000 as bad debt expense and add $10,000 to the allowance.
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Accounts Receivable Aging
- Categorize receivables by age and apply higher uncollectible percentages to older balances.
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Example:
- $200,000 (<30 days) × 1% = $2,000
- $50,000 (31–60 days) × 5% = $2,500
- $25,000 (61–90 days) × 20% = $5,000
- $10,000 (>90 days) × 50% = $5,000
- Total allowance = $12,500
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Risk Classification (Customer Segmentation)
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Assign different percentages to customer groups (e.g., enterprise, mid-market, small business) to reflect distinct payment behaviors.
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Historical Percentage
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Use a long-term average percentage of AR if the business and economic environment are stable.
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Pareto Analysis
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Focus detailed reviews on the relatively small number of customers that make up most receivables, applying standard percentages to smaller accounts.
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Specific Identification
- When feasible, evaluate individual accounts (e.g., bankrupt or legally disputed customers) and reserve specifically for those balances.
Accounting for the allowance
- Establishing the allowance
- Record bad debt expense and a corresponding increase to the allowance (contra-asset).
- Example: Expected uncollectible $75,000
- Debit Bad debt expense $75,000
- Credit Allowance for doubtful accounts $75,000
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Reported AR is reduced in net presentation (e.g., $1,500,000 AR less $75,000 allowance = $1,425,000 net AR).
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Adjusting the allowance
- Periodically re-estimate the required allowance and record the incremental change as bad debt expense (or reduce expense if allowance is lowered).
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Example: If allowance should be $90,000 but currently is $75,000, record an additional $15,000 of bad debt expense and increase the allowance by $15,000.
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Writing off uncollectible accounts
- When a specific account is deemed uncollectible, remove it from AR and reduce the allowance.
- Example: Write-off $7,200
- Debit Allowance for doubtful accounts $7,200
- Credit Accounts receivable $7,200
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No additional expense is recorded at write-off because expense was recognized when the allowance was established.
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Recoveries of written-off accounts
- If a previously written-off account pays, reinstate the receivable and the allowance, then record the cash collection.
- Example: Customer pays $2,500 previously written off
- Debit Accounts receivable $2,500
- Credit Allowance for doubtful accounts $2,500
- Then debit Cash $2,500 and credit Accounts receivable $2,500
Practical considerations and cautions
- The allowance involves judgment; use consistent, supportable methods and document assumptions.
- Significant or unexplained changes in methodology or allowance levels warrant scrutiny, as they can materially affect reported earnings.
- Not establishing an allowance and writing off bad debts only when they occur violates the matching principle and can cause erratic profit reporting.
Conclusion
The allowance for doubtful accounts converts the inevitability of some customer defaults into a disciplined accounting estimate. By recognizing expected credit losses when revenue is recorded, companies present more reliable financial statements, better assess credit risk, and make more informed credit and collection decisions.