What is an allowance for bad debts?
An allowance for doubtful accounts is a contra account which is deducted from the total claims presented on the balance sheet reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable which should be irrecoverable. However, the actual payment behavior of customers may differ significantly from the estimate.
Key points to remember
- The allowance for bad debts is an offset account that records the percentage of receivables that are believed to be uncollectible.
- The provision is established in the same accounting period as the original sale, with an offset for bad debts.
- The percentage of sales method and the aging accounts receivable method are the two most common methods for estimating uncollectible accounts.
Allowance for doubtful accounts
Understanding the Allowance for Doubtful Accounts
Regardless of company policies and procedures regarding credit collections, the risk of non-payment is always present in a credit transaction. Thus, a company is required to realize this risk by the constitution of the provision for bad debts and the compensation bad debt costs. In line with the peg accounting principle, this ensures that expenses related to the sale are recorded in the same accounting period as revenue is earned. The allowance for bad debts also helps businesses more accurately estimate the true value of their accounts receivable.
Since the allowance for bad debts is established in the same accounting period like the initial sale, an entity does not know with certainty which exact receivables will be paid and which will be in default. Therefore, generally accepted accounting principles (GAAP) state that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure. The allowance can accumulate over multiple accounting periods and can be adjusted based on account balance.
Recording of allowance for bad debts
There are two main methods for estimating the dollar amount of accounts receivable that are not expected to be collected.
Percentage of sales method
The sales method applies a fixed percentage to the total dollar amount of sales for the period. For example, based on past experience, a company might expect that 3% of net sales are not collectible. If total net sales for the period are $100,000, the company establishes an allowance for bad debts of $3,000 while simultaneously reporting $3,000 in bad debts.
If the next accounting period results in net sales of $80,000, an additional $2,400 is recorded in the allowance for doubtful accounts and $2,400 is recorded in the second period in the bad debt expense. The overall balance of the allowance for doubtful accounts after these two periods is $5,400.
Accounts Receivable Aging Method
The second method of estimating the allowance for bad debts is the aging method. All outstanding accounts receivable are grouped by age and specific percentages are applied to each group. The total of all group results is the estimated uncollectible amount.
For example, a business has $70,000 in accounts receivable that are less than 30 days past due and $30,000 in accounts receivable that are more than 30 days past due. Based on past experience, 1% of accounts receivable less than 30 days will be uncollectible, and 4% of those accounts receivable at least 30 days will be uncollectible.
Therefore, the company will report an allowance of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period results in an estimated provision of $2,500 based on unpaid accounts receivable, only $600 ($2,500 – $1,900) will be the amount of the adjusting entry.