What is Allowance for Doubtful Accounts? Definition Meaning Example

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. The allowance represents management’s best estimate of the amount of accounts receivable that will not be paid by customers. It does not necessarily reflect subsequent actual experience, which could differ markedly from expectations. If actual experience differs, then management adjusts its estimation methodology to bring the reserve more into alignment with actual results. When you encounter an invoice that has no chance of being paid, you’ll need to eliminate it against the provision for doubtful debts. You can do this via a journal entry that debits the provision for bad debts and credits the accounts receivable account.

Typically, accountants only use the direct write-off method to record insignificant debts, since it can lead to inaccurate income figures. For instance, if revenue is recorded in one period but expensed in another, this leads to an artificially high revenue number for that first period. The historical percentage method works best if you have a relatively small customer base and straightforward billing cycles. For instance, if all of your customers stick to similar credit cycles, the historical percentage method will help you calculate a realistic allowance for doubtful accounts.

Method 2: Accounts receivable aging

Assign a risk score to each customer, and assume a higher risk of default for those having a higher risk score. This brings your total for those two groups to a doubtful accounts definition doubtful account allowances of $2,125. A mortgage is not a loan because the borrower has the potential to profit from a rise in the price of his or her home.

• All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance.
• Assign a risk score to each customer, and assume a higher risk of default for those having a higher risk score.
• Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP.
• When you need to create or increase a provision for doubtful debt, you do it on the ‘credit’ side of the account.
• In other words, AFDA is an estimate while BDE records the actual impact of uncollectibles.

Incorrect AR data also cripples accrual accounting processes, leading to false revenue and cash flow figures. A contra-asset decreases the dollar amount of the asset with which it is paired. In AFDA’s case, it is paired with accounts receivable and reduces its value on the balance sheet. Allowance for doubtful accounts helps companies account for unpaid invoices.

Allowance for Doubtful AccountsDefinition, Methods, and How to Record Allowance for Doubtful Accounts

In addition, this accounting process prevents the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses. If a company is using the accrual basis of accounting, it should record an allowance for doubtful accounts, since it provides an estimate of future bad debts that improves the accuracy of the company’s financial statements. The allowance for doubtful accounts is the preferred method of accounting for doubtful accounts. It is a contra-asset account netted against accounts receivable on the balance sheet. The allowance is increased by the provision for doubtful accounts and recoveries of previously written off receivables and is decreased by the write-off of uncollectible receivables.

When you extend credit to a customer, there is a chance that they will not pay you. For example, the customer may go out of business or refuse to pay based on a dispute. Doubtful accounts have not been written off yet, but there is reason to believe that payment may not come. The credit balance in this account comes from the entry wherein Bad Debts Expense is debited. The amount in this entry may be a percentage of sales or it might be based on an aging analysis of the accounts receivables . Using the example above, let’s say that a company reports an accounts receivable debit balance of $1,000,000 on June 30. The company anticipates that some customers will not be able to pay the full amount and estimates that $50,000 will not be converted to cash.