How to Calculate Allowance for Doubtful Accounts

The allowance for doubtful accounts is a financial reporting estimate that businesses make to account for the portion of money owed to them that they do not expect to collect. This estimate ensures assets are not overstated on a company’s balance sheet, reflecting a more realistic value of expected cash inflows. This is a proactive accounting measure, anticipating potential losses.

Understanding Accounts Receivable and Bad Debts

Accounts receivable represents money owed to a company by its customers for goods or services that have been delivered on credit. However, not all promises are kept, leading to “bad debts”—accounts receivable deemed uncollectible.

Bad debts arise from reasons like customer bankruptcy, financial difficulties, or disputes. To address this, accounting standards require the use of the allowance method, which aligns with the matching principle.

This principle dictates that expenses should be recognized in the same accounting period as the revenues they helped generate, ensuring financial statements accurately reflect profitability. Therefore, the estimated expense of uncollectible accounts is recognized in the period when the related credit sales were made, rather than waiting for specific accounts to become uncollectible.

Estimating Uncollectible Accounts: Percentage of Sales Method

One common approach to estimating uncollectible accounts is the percentage of sales method, also referred to as the income statement approach. This method focuses on estimating the bad debt expense for a given period based on a percentage of the company’s credit sales. This method assumes a percentage of credit sales will become uncollectible, based on historical data or industry averages.

To calculate the bad debt expense using this method, the total credit sales for the period are multiplied by the estimated uncollectible percentage. For instance, if a business has $500,000 in credit sales for a period and estimates that 2% will be uncollectible, the calculation would be straightforward. The bad debt expense would be $500,000 multiplied by 0.02, resulting in an estimated bad debt expense of $10,000. This calculated amount directly represents the bad debt expense for the current period.

This method directly calculates the expense for the income statement; it does not adjust the existing allowance balance to a desired ending balance. The allowance account increases by this expense.

Estimating Uncollectible Accounts: Percentage of Receivables Method

Another widely used approach for estimating uncollectible accounts is the percentage of receivables method, often known as the aging of receivables method. This method focuses on the balance sheet and aims to determine the desired ending balance in the allowance for doubtful accounts.

It involves categorizing outstanding accounts receivable based on how long they have been unpaid, creating an “aging schedule.” Older receivables are generally considered less likely to be collected and are assigned higher uncollectibility percentages.

An aging schedule typically divides receivables into time brackets such as current (not yet due), 1-30 days past due, 31-60 days past due, 61-90 days past due, and over 90 days past due. A specific uncollectibility percentage is then applied to the total amount of receivables within each age category. The estimated uncollectible amount for each category is calculated by multiplying the accounts receivable balance in that category by its assigned percentage.

These individual estimated uncollectible amounts are then summed to arrive at the total estimated allowance for doubtful accounts needed at the end of the period. For instance, if current receivables of $100,000 are 1% uncollectible ($1,000), 31-60 day receivables of $50,000 are 10% uncollectible ($5,000), and 61-90 day receivables of $20,000 are 25% uncollectible ($5,000), the total required allowance would be $11,000. If the existing allowance account has a credit balance of $2,000, the bad debt expense recorded would be $9,000 ($11,000 – $2,000). This method provides a more precise estimate of the net realizable value of accounts receivable on the balance sheet.

Recording the Allowance and Bad Debt Write-Offs

Once the estimated bad debt expense is determined, it is recorded in the company’s accounting records. The journal entry to recognize this expense involves a debit to “Bad Debt Expense” and a credit to “Allowance for Doubtful Accounts.” This entry increases the bad debt expense on the income statement, reflecting the cost of extending credit. Simultaneously, the “Allowance for Doubtful Accounts” is a contra-asset account that reduces the total accounts receivable on the balance sheet, ensuring assets are not overstated.

When a specific customer’s account is definitively identified as uncollectible, it is then written off. This write-off does not create a new bad debt expense because the expense was already estimated and recorded in a prior period through the allowance method.

The journal entry to write off a specific account involves a debit to “Allowance for Doubtful Accounts” and a credit to “Accounts Receivable.” This action reduces both the allowance account and the specific customer’s accounts receivable balance, but it does not impact the total assets or net income at the time of the write-off.

In some instances, a company may unexpectedly collect an account that was previously written off. When this occurs, a two-part journal entry records the recovery.

First, the original write-off is reversed by debiting “Accounts Receivable” and crediting “Allowance for Doubtful Accounts,” reinstating the receivable. Second, the cash collection is recorded by debiting “Cash” and crediting “Accounts Receivable,” reflecting the receipt of funds. This process ensures accurate tracking of all transactions related to uncollectible accounts.