How to Record an Allowance for Doubtful Accounts

As per IFRS 9, a company needs to estimate the “Expected Credit Losses” based on clear and objective evaluation criteria, which need to be documented by the management. To learn more about how we can help your business grow, normal balance of accounts contact one of our sales agents by filling out the form below. Our credit risk assessment services also allow you to thoroughly evaluate customer creditworthiness and make informed decisions about whom to extend credit to.

Especially since the debt is now being reported in an accounting period later than the revenue it was meant to offset. An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable. The allowance, sometimes called a bad debt reserve, represents management’s estimate of the amount of accounts receivable that will not be paid by customers. An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible.

Accounts Receivable Aging Method

For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for https://www.bookstime.com/blog/sales-forecasting doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense. The bad debt expense account is the only account that impacts your income statement by increasing expenses.

• To account for potential bad debts, a company debits the bad debt expense and credits the allowance for doubtful accounts.
• This means the company has reached a point where it considers the money to be permanently unrecoverable, and must now account for the loss.
• The AFDA recognizes and records expected losses from unpaid customer invoices or accounts receivable (A/R).
• An allowance for doubtful accounts is a technique used by a business to show the total amount from the goods or products it has sold that it does not expect to receive payments for.
• The allowance is an estimated reserve for potential bad debts, while bad debt expense is the actual amount recognized as a loss when a specific account is deemed uncollectible.

All other activities around the allowance for doubtful accounts will impact only your balance sheet. 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. This account reflects a zero or credit balance; hence it is considered an asset. This is where a company uses historical data of defaults to calculate the allowance for doubtful accounts.

Historical data

You should review the balance in the allowance for doubtful accounts as part of the month-end closing process, to ensure that the balance is reasonable in comparison to the latest bad debt forecast. For companies having minimal bad debt activity, a quarterly update may be sufficient. This method is also known as the “80/20” rule and is ideally used by business entities with a small number of large invoice balances. Here, the doubtful account balance combines the above two methods, where the risk method is typically used for the larger clients (80%), and the historical method is used for the smaller clients (20%).

Properly managing the allowance for doubtful accounts ensures that your financial statements are accurate and up-to-date. It is important to understand that the allowance doesn’t protect against slow payments or lessen the impact of bad debt losses. 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. As you can tell, there are a few moving parts when it comes to allowance for doubtful accounts journal entries. To make things easier to understand, let’s go over an example of bad debt reserve entry.