Loading the player...

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 amounts expected to be repaid. 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. The allowance for doubtful accounts is only an estimate of the amount of accounts receivable which are expected to not be paid. The actual payment behavior of customers may differ substantially from the estimate.

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 establishes 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 is 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 is 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.

RELATED TERMS
  1. Net Receivables

    Net receivables is the total money owed to a company by its customers ...
  2. Allowance For Bad Debt

    An allowance for bad debt is a valuation account used to estimate ...
  3. Accounts Receivable - AR

    Accounts receivable is the balance of money due to a firm for ...
  4. Accounting

    Accounting is the systematic and comprehensive recording of financial ...
  5. Account Balance

    An account balance is the amount of money in a financial repository, ...
  6. Account Activity

    Account activity generically applies to whenever a movement of ...
Related Articles
  1. Personal Finance

    Handling High-Yield Savings Accounts

    Is a high-yield savings account right for you? Read on to find out what they have to offer.
  2. Investing

    Accounts Receivable

    Accounts Receivable (A/R) is an accounting term used to refer to the money that is owed to a company by its customers.
  3. Investing

    Spotting Creative Accounting on the Balance Sheet

    Companies have used creative accounting as a way of manipulating their balance sheets.
  4. Managing Wealth

    Accounting Research Manager: Career Path & Qualifications

    Discover the basic responsibilities of an accounting research manager, the path this career usually takes and the qualifications needed for this career.
  5. Small Business

    Best Checking Accounts For Small Businesses

    What you need to know to choose the best checking account for your small business – and where to look.
  6. Personal Finance

    The Complete Guide to Checking Accounts

    Here is the A to Z of checking accounts: types of accounts, basics on check writing, debit cards, overdraft protection and much more.
  7. Investing

    What is Accounting?

    Accounting is the recording of financial transactions of a business or organization. It also includes the process of summarizing, analyzing and reporting these transactions in financial statements.
  8. Personal Finance

    10 Bank Promotions That Pay You To Open An Account

    Find out which banks are running cash promotions this summer.
RELATED FAQS
  1. What is cost accounting?

    Learn about the main benefits of cost accounting systems, how they are different from financial accounting and why they are ... Read Answer >>
  2. What's the difference between the current account and the capital account?

    Both accounts relate to the balance of payments of a nation. One considers goods and services currently produced, the other ... Read Answer >>
  3. What Does a Share Liquidation in My Account Mean?

    A liquidation occurs when an account's holdings are sold off by the firm where the account was held. Read Answer >>
  4. Why choose a money market account instead of a savings account?

    Learn how money market and savings accounts differ and why a depositor would choose a money market over a savings account. Read Answer >>
Trading Center