What is an 'Allowance For Doubtful Accounts'
An allowance for doubtful accounts is a contra-asset account that reduces the total receivables reported to reflect only the accounts receivable expected to be collected. The allowance is established by recognizing a bad debt loss on the financial statements in the same accounting period when the associated sale is reported.
BREAKING DOWN 'Allowance For Doubtful Accounts'Only entities that extend credit to their customers use an allowance for doubtful accounts. Regardless of company policies and procedures for credit collections, the risk of the failure to receive payment is always present in a transaction utilizing credit. Thus, a company is required to realize this risk through the establishment of the allowance.
Timing of Allowance for Doubtful Accounts
The allowance for doubtful accounts is established in the same accounting period in which a sale is performed. This creates the issue of knowing exactly how much to establish the allowance for. Since no significant period of time has passed since the sale, an entity does not know which exact accounts receivable will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) rule that the allowance must still be established in the same accounting period as the sale but is based on an anticipated and estimated figure. The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.
Estimation of Allowance for Doubtful Accounts
Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected. The sales method utilizes the total dollar amount of sales for the period, as a flat percentage is applied to this amount. For example, based on previous experience, a company may expect that 3% of net sales are not collected. If the total net sales for the period is $100,000, the company cab establish an allowance for doubtful accounts for $3,000. If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.
The second method of estimating the allowance for doubtful accounts in the aging method. All outstanding accounts receivable are grouped by age, and specific periods are applied to each group. The aggregate of all groups results in the estimated uncollectible accounts receivable. For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable at least 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will not be collected and 4% of accounts receivable at least 30 days old go uncollected. Therefore, the company will report an allowance of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next account period results in an estimated allowance of $2,500, only $600 ($2,500 - $1,900) will be the adjusted dollar amount.