An allowance for doubtful accounts is a contra asset account used by businesses to estimate the total amount of goods and services sold that they do not expect to receive payment for. Located on your balance sheet, the allowance for doubtful accounts is used to offset your accounts receivable account balance.
What is an allowance for doubtful accounts (ADA)?
As a small business owner, you take a giant leap of faith every time you extend credit to your customers. Even with the most stringent analysis of a customer’s ability to pay, there’s going to be a time when a customer (or two) doesn’t pay what they owe.
And while uncollectible account balances can be written off at year-end, for accounting purposes, it’s better to account for bad debt expenses up front using the allowance for doubtful accounts (ADA) rather than writing off a large number of bad debts at year-end.
That’s what the allowance for doubtful accounts is for. The ADA is a contra asset account, meaning it works to offset the account with which it is associated with. Because the allowance for doubtful accounts is used with your accounts receivable account, the ADA works to reduce your accounts receivable balance.
The allowance for doubtful accounts is easily managed using any current accounting software application. For those of you using manual accounting journals, you’ll have to make appropriate entries to your journals to manage ADA totals properly.
Who uses allowance for doubtful accounts (ADA)?
If you’re using the accrual method of accounting, you should be using the allowance for doubtful accounts in your business.
Even if you’ve been in business for less than a year and have no historical information on hand to help estimate the amount that should be recorded in an ADA, a conservative guess is better than nothing, and you can adjust the totals as more historical data becomes available.
And because the balance in the allowance for doubtful accounts reduces or offsets your accounts receivable balance, using this contra asset account will contribute to more accurate financial statements.
If you have a lot of accounts receivable activity, it’s helpful to adjust your ADA balance monthly, but if the activity is limited, a quarterly adjustment should be sufficient.
How to estimate the allowance for doubtful accounts (ADA)
There are a variety of allowance methods that can be used to estimate the allowance for doubtful accounts. While the historical basis is probably the most accurate allowance method, newer businesses will likely have to make a conservative “best guess” until they have a basis they can use.
1. Risk classification
The risk classification method assumes that you have prior knowledge of the customer's payment history, either through your initial credit analysis or by running a credit report. Analyzing the risk may give you some additional insight into which customers may default on payment.
2. Historical percentage
Perhaps the most effective method, the historical percentage uses past bad debt totals to predict your ADA for the current year. For example, if last year your accounts receivable balance was $40,000, and you had $4,000 in bad debt, you could use this information to predict bad debt totals for the current year.
3. Percentage of sales
Perhaps the best method for new businesses without a valid customer payment history, you simply calculate a percentage of your accounts receivable as a doubtful account, revisiting the percentage periodically to determine how close (or not) your estimate was, and make any needed adjustments for the upcoming accounting period.
Examples of an allowance for doubtful accounts (ADA)
Here are a few examples of how to calculate your allowance for doubtful accounts.
ADA example 1
Last year, 10% of your accounts receivable balance ended up as bad debt. Since then, you’ve improved customer screening and instituted better collection procedures.
With sales estimated to be $60,000 for the year, you determine that your allowance for doubtful accounts should be 5%. The calculation to determine the ADA would be:
$60,000 x 5% = $3,000
To record the $3,000 allowance for doubtful accounts, you’ll need to complete the following journal entry:
|1/31/2020||Bad Debt Expense||$3,000|
|1/31/2020||Allowance for Doubtful Accounts||$3,000|
The bad debt expense account is the only account that impacts your income statement by increasing expenses. All other activities around the allowance for doubtful accounts will impact only your balance sheet.
Recording the above journal entry will offset your current accounts receivable balance by $3,000. For example, if your current accounts receivable balance is $8,000, the actual value of the account would be $5,000.
Remember that the allowance for doubtful accounts is just an estimate. It’s only when a customer defaults on their balance owed that you‘ll need to adjust both the ADA balance and the accounts receivable balance with the following journal entry.
For example, at year-end, you determine that you’re unable to collect on a $1,000 invoice, requiring you to make the following journal entry.
|12/31/2020||Allowance for Doubtful Accounts||$1,000|
This entry permanently reduces the accounts receivable balance in your general ledger, while also reducing the allowance for doubtful accounts.
ADA example 2
Using the percentage of sales method, when reviewing your current accounts receivable, you estimate that 15% of your current receivables will be uncollectible. If your current accounts receivable balance is $25,000, you calculate the ADA balance as follows:
$25,000 x 15% = $3,750
At the end of the year, you determine that $2,000 of the $3,750 is uncollectible and should be written off. You can do so with the following journal entry:
|12/31/2020||Allowance for Doubtful Accounts||$2,000|
A month later, after the funds have been written off, one of your customers makes a $1,500 payment. The first journal entry reduces the allowance for doubtful accounts while increasing your accounts receivable balance.
|12/31/2020||Allowance for Doubtful Accounts||$1,500|
To record the payment itself, you would then debit cash, and credit accounts receivable.
Is the allowance for doubtful accounts important for your business?
If you don’t sell to customers on credit, there’s no need to use the allowance for doubtful accounts. But if you do, you’re bound to have some bad debt, and the most accurate way to properly account for that bad debt is to use a contra asset account to estimate what you think your totals will be for the year.
Using the allowance for doubtful accounts is particularly important to maintain financial statement accuracy, which should be important to any business owner, no matter how large or how small your business may be.
Using the allowance for doubtful accounts enables you to create financial statements that offer a more accurate representation of your business.
There are several methods you can use when estimating your allowance for doubtful accounts. Whatever method you choose, if you offer your customers credit, you should start using this contra asset account today.