Allowance for Doubtful Accounts Purpose and Estimation with Examples

balance sheet allowance for doubtful accounts

The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. This variance in treatment addresses taxpayers’ potential to manipulate when a bad debt is recognized. The company would then record a journal entry at the end of the accounting period that includes a debit to the bad debt expense account for $3,000 and a credit to the allowance for doubtful accounts for $3,000. If this is your first time recording the allowance, you simply debit your bad debt expense account and credit your allowance account for the same amount.

balance sheet allowance for doubtful accounts

The company now has a better idea of which account receivables will be collected and which will be lost. For example, say the company now thinks that a total of $600,000 of receivables will be lost. The company must record an additional expense for this amount to also increase the allowance’s credit balance.

Pareto Analysis Method

The AFDA helps accountants estimate the amount of bad debt that is expected to be uncollectable and adjusts the accounts receivables balance accordingly. This ensures that the company’s financial statement accurately reflects its overall financial health. The estimated bad debt percentage is then applied to the accounts receivable balance at a specific time point. By estimating the allowance for doubtful accounts, companies can accurately reflect their financial position and ensure they have enough reserves to cover potential losses from uncollectible accounts.

Yes, allowance accounts that offset gross receivables are reported under the current asset section of the balance sheet. This type of account is a contra asset that reduces the amount of the gross accounts receivable account. The second method of estimating the allowance for doubtful accounts is the aging method. All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group.

How to remember which side to Debit/Credit

To do this, companies use various methods to calculate the estimated number of uncollectible accounts that need to be reserved. The purpose of allowance for doubtful accounts is to manage the risk of uncollectible accounts. Companies often extend credit to customers and allow them to pay at a later date. Contra assets are accounts used to reduce the value of a related asset account on the balance sheet. They are recorded with a credit balance, opposite to asset accounts’ normal debit balance.

The matching principle states that revenue and expenses must be recorded in the same period in which they occur. Therefore, the allowance is created mainly so the expense can be recorded in the same period revenue is earned. You record the allowance for doubtful accounts by debiting the Bad Debt Expense account and crediting the Allowance for Doubtful Accounts account. You’ll notice the allowance account has a natural credit balance and will increase when credited.

B2B Payments

A third way to calculate the allowance for doubtful accounts is the customer risk classification method. For this method, you assign each customer a default risk percentage based on their payment history. Some companies may classify different types of debt or different types of vendors using risk classifications. For example, a start-up customer may be considered a high risk, while an established, long-tenured customer may be a low risk. In this example, the company often assigns a percentage to each classification of debt.

Thus the allowance for doubtful accounts for the period ending starting that month will be zero in the beginning. When this accounting entry is passed, the total account receivable on the balance sheet will be $400,000 and is known as the net realizable value of accounts receivables. The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable.