In some cases, the company may still pursue collection through a collection agency, legal action, or other means. Let’s explore the importance of allowance for doubtful accounts, the methods of estimating it, and how to record it. By a miracle, it turns out the company ended up being rewarded a portion of their outstanding receivable balance they’d written off as part of the bankruptcy proceedings. Of the $50,000 balance that was written off, the company is notified that they will receive $35,000. Companies have been known to fraudulently alter their financial results by manipulating the size of this allowance.

The customer has $5,000 in unpaid invoices, so its allowance for doubtful accounts is $500, or $5,000 x 10%. If you use the accrual basis of accounting, you will record doubtful accounts in the same accounting period as the original credit sale. This will help present a more realistic picture of the accounts receivable amounts you expect to collect versus what goes under the allowance for doubtful accounts.

How to Calculate Allowance For Doubtful Accounts (3 ways)

Therefore, it reduces the value of shareholders’ equity by the amount paid for those repurchased stocks. For example, an asset was purchased by a company for $100,000 – that is, the historical cost of the asset was $100,000 – and its contra asset counterpart has a balance of $30,000. Properly managing the allowance for doubtful accounts ensures that your financial statements are accurate and up-to-date. The allowance for doubtful accounts is not always a debit or credit account, as it can be both depending on the transactions. When a doubtful account becomes uncollectible, it is a debit balance in the allowance for doubtful accounts. Yes, GAAP (Generally Accepted Accounting Principles) does require companies to maintain an allowance for doubtful accounts.

There are two primary methods for estimating the amount of accounts receivable that are not expected to be converted into cash. Accounts use this method of estimating the allowance to adhere to the matching principle. 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. This post covers everything you need to know about the allowance for doubtful accounts.

What is a Contra Account?

Also known as the contra account, the allowance for doubtful accounts is an estimated percentage of the accounts receivable that are not expected to be collectible. However, this is not even a close representation of the actual payment behavior of customers, as it may differ substantially. The allowance, also known as a bad debt reserve, provides a picture of management’s estimate of the expected uncollectible accounts receivable. By reporting contra asset accounts on the balance sheet, users of financial statements can learn more about the assets of a company. Contra asset accounts allow users to see how much of an asset was written off, its remaining useful life, and the value of the asset. The AFDA recognizes and records expected losses from unpaid customer invoices or accounts receivable (A/R).

Contra liability accounts are special accounts in the liabilities section of the balance sheet. This would let users of the financial statements calculate the book value of the liability. A contra asset account is an account in the balance sheet that offsets the balance of a regular asset account. At Allianz Trade, we can help by providing you with trade credit insurance services and tools needed to reduce the uncertainty of buyer default and greatly reduce the impact of bad debt. It can also help you to estimate your allowance for doubtful accounts more accurately. It is important to understand that the allowance doesn’t protect against slow payments or lessen the impact of bad debt losses.

Allowance Method: Journal Entries (Debit and Credit)

As such, effective credit management and debt collection procedures should be a critical part of the evaluation of how to limit the effect bad debt can have on your business. Accountants use allowance for doubtful accounts to ensure that their financial statements accurately reflect the current state of their receivables. With accounting software like QuickBooks, you can access important insights, including your allowance for doubtful accounts. With such data, you can plan for your business’s future, keep track of paid and unpaid customer invoices, and even automate friendly payment reminders when needed. The accounts receivable aging method uses accounts receivable aging reports to keep track of past due invoices.

• On the balance sheet, an allowance for doubtful accounts is considered a “contra-asset” because an increase reduces the accounts receivable (A/R) account.
• Auditors look for this issue by comparing the size of the allowance to gross sales over a period of time, to see if there are any major changes in the proportion.
• There are also downsides to having too small or too large of an allowance for doubtful accounts.
• Both the asset and the corresponding contra asset accounts must be stated clearly in the balance sheet.
• While assets have natural debit balances and increase with a debit, contra assets have natural credit balance and increase with a credit.
• GAAP allows for this provision to mitigate the risk of volatility in share price movements caused by sudden changes on the balance sheet, which is the A/R balance in this context.
• In some cases, the company may still pursue collection through a collection agency, legal action, or other means.

Additionally, the allowance for doubtful accounts in June starts with a balance of zero. This is where a company uses historical data of defaults to calculate the allowance for doubtful accounts. The company considers the past five years’ data of unpaid accounts and then computes the allowance for doubtful accounts is a contra asset account that equals the total unpaid invoices for each year in a percentage form. The company now looks at total sales hereon and then multiplies it by the percentage. Accumulated depreciation is a contra asset account used to record the amount of depreciation to date on a fixed asset.

If the asset account had a credit balance or the contra asset account had a debit balance, this would indicate an error in the journal entries. While the allowance for doubtful accounts is a useful accounting method that can help assess the true value of the accounts receivable asset, it has shortfalls that need to be considered. It is impossible to know which customers will default in a given year, which makes the process inherently inaccurate. If a large customer defaults unexpectedly, the allowance for doubtful accounts will not protect a company from suffering significant impacts to cash flow and profitability. The estimated bad debt percentage is then applied to the accounts receivable balance at a specific time point. By estimating the expected uncollectible debts and creating an allowance for them, you can minimize the risk of significant losses arising from bad debts and ensure accurate financial statements.

• To oppose the revenue made by a company, contra revenue accounts must have a debit balance.
• All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group.
• Businesses can use the proper methods to estimate the AFDA to ensure their balance sheets remain accurate and up-to-date.
• In many different aspects of business, a rough estimation is that 80% of account receivable balances are made up of a small concentration (i.e. 20%) of vendors.
• The auditors aim to keep the balances at their adequate levels, but the controller might want to keep them as low as possible to reduce expenses and maximize profit levels.

Then use the preceding historical percentage method for the remaining smaller accounts. Whenever the balance of a contra asset account increases (credit to the contra asset account), the increased amount is written off as an expense and is reported in the company’s income statement. 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. Then, the company establishes the allowance by crediting an allowance account often called ‘Allowance for Doubtful Accounts’.