Allowance for doubtful accounts & bad debt expenses: Calculation

The concepts of allowance for doubtful accounts and bad debt expenses play a pivotal role in portraying an accurate picture of a company's financial health. 

This article delves into the intricacies of these two crucial accounting terms, providing a comprehensive understanding of their definitions, their significance in financial reporting, and the methodologies employed to calculate them.

What is a doubtful account?

A doubtful account, also known as a bad debt or uncollectible account, is an account receivable that a company has justifiable reason to believe it may not collect the full credit balance or at all. It represents an estimate of the portion of accounts receivable that is expected to become uncollectible due to various reasons, such as customer insolvency, bankruptcy, or inability to pay.

What causes doubtful accounts?

Doubtful accounts arise due to the inherent risk associated with extending credit to customers. Some common reasons for accounts becoming doubtful include:

• Financial difficulties of the customer: The customer may experience financial hardship, making it difficult or impossible for them to fulfill their payment obligations.
• Disputes over goods or services: Disputes may arise regarding the quality, quantity, or delivery of goods or services, leading to the customer refusing to pay.
• Fraudulent activity: The customer may engage in fraudulent activity, such as providing false information or absconding with the goods without paying.
• Economic downturns: During economic downturns, businesses may experience a decline in sales and revenue, making it difficult for them to pay their debts.
  
  

What is allowance for doubtful accounts?

Allowance for uncollectible accounts is an estimate of the portion of accounts receivable that is expected to become uncollectible. The allowance method represents accounts receivable that a company has justifiable reason to believe it may not collect in full or at all.

Why track doubtful accounts?

Tracking doubtful accounts is essential for several reasons:

• To provide an accurate representation of a company's financial health by reflecting the realistic value of its accounts receivable.
• To ensure compliance with accounting principles, such as the matching principle, which requires expenses to be recognized in the same period as the related revenue.
• To aid in making informed decisions about credit policies and risk management.
• To prevent overstating assets on the balance sheet.
  
  

How to estimate an allowance for doubtful accounts

Estimating the allowance for doubtful accounts is crucial for accurate financial reporting. It ensures that the balance sheet reflects a realistic picture of the company's assets and helps prevent overstatement of income.

Methods for estimating the allowance

There are several methods commonly used to estimate the allowance for doubtful accounts on the balance sheet:

1. Percentage of sales method:
   • This method involves applying a predetermined percentage to the total credit sales for a period. The percentage is based on historical collection experience and industry averages.
   • It is a simple and straightforward method, but it may not accurately reflect the specific aging of individual accounts receivable.
2. Percentage of receivables method:
   • This method applies a percentage to the total accounts receivable balance at the end of a period.
   • The percentage is often based on an aging schedule that categorizes receivables by age and assigns different percentages to each category based on the likelihood of collection.
   • This method is more refined than the percentage of sales method as it considers the age of receivables.
3. Aging of receivables method:
   • This aging method is the most commonly used and considered the most accurate by finance teams.
   • It involves creating an aging schedule that categorizes outstanding accounts receivable by age (e.g., 0-30 days, 31-60 days, 61-90 days, over 90 days).
   • Based on historical collection experience, different percentages are applied to each age category to estimate the uncollectible amount.
   • The sum of the estimated unpaid invoices for each category represents the total allowance for doubtful accounts.
     
     

How to calculate allowance for doubtful accounts

The step-by-step guide below shows how to calculate an allowance for doubtful accounts using the aging of receivables method, which is considered the most accurate:

Step 1: Create an aging schedule

• Categorize accounts receivable by age. Common categories include:
  • 0-30 days past due
  • 31-60 days past due
  • 61-90 days past due
  • Over 90 days past due
• List each customer with outstanding receivables and the late payment owed in the appropriate age category.

Step 2: Assign percentages to each age category

• Based on historical collection experience and industry averages, determine the percentage of uncollectible accounts for each age category.
• Generally, the older the receivable, the higher the percentage assigned.
  • Example: 1% for 0-30 days, 5% for 31-60 days, 15% for 61-90 days, and 30% for over 90 days.

Step 3: Calculate estimated uncollectible amounts for each category

• Multiply the total amount of receivables in each age category by the corresponding percentage assigned.
  • Example:
    • 0-30 days: $10,000 * 1% = $100
    • 31-60 days: $5,000 * 5% = $250
    • 61-90 days: $2,000 * 15% = $300
    • Over 90 days: $1,000 * 30% = $300

Step 4: Sum the estimated uncollectible amounts

• Add up the estimated uncollectible amounts from each age category.
  • Example: $100 + $250 + $300 + $300 = $950

Step 5: Record the allowance for doubtful accounts

• The total amount calculated in step 4 ($950 in the example) is the estimated allowance for doubtful accounts.
• This amount is recorded as a contra-asset account on the balance sheet, reducing the net realizable value of accounts receivable.
  
  

Doubtful accounts vs bad debt

Doubtful accounts, also known as bad debt or uncollectible accounts, are accounts receivable that a company believes it may not collect in full or at all. It's an estimate of the portion of accounts receivable that is expected to become potential losses.

Bad debt is the specific amount of accounts receivable that has been determined to be uncollectible and is written off. It is the actual loss incurred when a customer's account is deemed uncollectible.

Key differences between doubtful accounts and bad debt

How to record an allowance for doubtful accounts journal entry

To record an allowance for doubtful accounts journal entry, you typically make an adjusting entry at the end of an accounting period. This entry recognizes the estimated amount of uncollectible accounts and adjusts the balance of the allowance for doubtful accounts.

Here's the primary methods:

Journal entry:

Explanation:

• Bad debt expense: This is an expense account that reflects the estimated amount of uncollectible accounts for the current period. It is debited, increasing the expense on the income statement.

• Allowance for doubtful accounts: This is a contra-asset account that reduces the carrying value of Accounts Receivable on the accounting books. It is credited, increasing the allowance and decreasing the net realizable value of Accounts Receivable.

Example:

If the estimated allowance for doubtful accounts is $950, the journal entry for allowance for doubtful accounts would be:

This entry records the estimated $950 as an expense and increases the allowance for doubtful accounts by the same amount, reflecting the reduced value of accounts receivable.

Key takeaways

1. Doubtful accounts are estimates of uncollectible accounts receivable, while bad debt is the specific amount written off.
2. Tracking doubtful accounts is essential for accurate financial reporting and risk management.
3. The aging of receivables method is considered the most accurate way to estimate the allowance for doubtful accounts.
4. The allowance for doubtful accounts is a contra-asset account that reduces the net realizable value of accounts receivable.
5. A journal entry is made to record the estimated allowance, debiting bad debt expense and crediting the allowance for doubtful accounts.
   
   

FAQs

What does AFDA stand for?

AFDA stands for Allowance for Doubtful Accounts. AFDA accounting is an estimate of the portion of accounts receivable that a company expects to become uncollectible.

What is the purpose of doubtful accounts?

Doubtful accounts are an estimate of the portion of accounts receivable that a company expects to become uncollectible, reflecting the risk of customers not paying their debts. Tracking doubtful accounts provides an accurate representation of a company's financial health and ensures compliance with accounting principles.

How does the allowance for doubtful accounts affect the income statement and balance sheet?

The allowance for doubtful accounts reduces the net realizable value of accounts receivable on the balance sheet, while the associated bad debt expense increases expenses on the income statement. These adjustments ensure that financial statements reflect a more accurate picture of the company's financial health.

Is allowance for doubtful accounts an asset?

No, the allowance for doubtful accounts is not an asset. What type of account is allowance for doubtful accounts? It is a contra-asset account.

Is allowance for doubtful accounts a contra asset?

Yes.

Is allowance for doubtful accounts a debit or credit?

 The allowance for doubtful accounts is a credit. It is a contra-asset account, meaning it reduces the overall value of accounts receivable on the balance sheet.

Is allowance for doubtful accounts a current asset?

No, allowance for doubtful accounts is not a current asset. It is a contra-asset account.

How to account for the allowance for doubtful accounts?

The allowance for doubtful accounts is an estimate of uncollectible receivables. It's determined using methods like percentage of sales, receivables, or aging. An adjusting journal entry is made, debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts. 

This allowance is deducted from Accounts Receivable on the balance sheet to show the Net Realizable Value. When an account is written off, Allowance for Doubtful Accounts is debited, and Accounts Receivable is credited, without affecting Bad Debt Expense, as it was already recognized.

What happens if the allowance for doubtful accounts is overestimated or underestimated?

If the allowance is overestimated, net income is understated, and if it is underestimated, net income is overstated. Adjustments are required to correct the allowance and ensure financial statements accurately reflect the company's financial position.

What happens if bad debt exceeds allowance?

When bad debt surpasses the allowance for doubtful accounts, the initial estimate of uncollectible amounts was underestimated. 

Corrective action is required, involving recognizing the actual bad debt, assessing the shortfall, adjusting the allowance through a journal entry that debits Bad Debt Expense and credits Allowance for Doubtful Accounts, and reflecting the impact on the Income Statement and Balance Sheet. 

This process ensures the financial statements accurately represent accounts receivable value and associated risks.

How to write off doubtful accounts?

 When an account is determined to be uncollectible, you debit the Allowance for Doubtful Accounts and credit Accounts Receivable. This entry removes the uncollectible amount from both the allowance and the receivables balance.

When should you write off bad debt?

Bad debt should be written off when it is determined that a specific account receivable is uncollectible. This decision is typically made after exhausting all reasonable collection efforts and assessing the customer's financial situation.

How can automation and AI help reduce the number of doubtful accounts?

Automation can streamline credit management processes, enabling faster identification of overdue accounts. AI can analyze customer payment patterns and predict which accounts are likely to become doubtful, allowing for proactive intervention. 

What Is the average industry-wise allowance for doubtful accounts?

There isn't a universal average industry-wise allowance for doubtful accounts normal balance for doubtful accounts since it varies significantly based on the specific industry, its customer base, credit policies, and economic conditions. Companies in industries with higher credit risk or longer collection cycles generally have higher allowances for doubtful accounts.