Why allowance for doubtful accounts

This is more of a pro-active approach taken by companies instead of waiting to see how the payment methodology is working out where the business will pass a debit entry for the bad debt expense and similarly make a credit entry as the allowance for doubtful accounts. Thus the allowance for doubtful accounts for the period ending starting that month will be zero in the beginning. There are generally two methods of estimating the allowance of doubtful accounts required which are as follows and a brief description about each one of them is given:.

The journal entry goes as follows where a debit entry is made against the bad debt expense and a credit entry is passed as an allowance for doubtful accounts. Doubtful account is considered as an asset in the balance sheet. The accounts is shown in the balance sheet in the asset section itself just below the accounts receivables line item.

Doubtful accounts are generally considered as a contra account which means it an account that will have either zero balance or a credit balance. Any amount which is added to the allowance for a doubtful account will always mean an amount for the deduction. Recording any amount here means that the business can easily see the extent of bad debt which is expected by the business and how much it is creating an offset to the total accounts receivables of the company.

The direct write off method is when the bad debt is directly charged to the expense line as soon as the business realizes that a particular invoice will not be paid whereas allowance for doubtful accounts is a method of estimation which is done on a prior basis as soon as the sale is made.

Thus, bad debt recognition takes place at a delayed stage in the direct write off method whereas the recognition is immediate in the case of the allowance method. Thus under the direct write off method, it leads to higher initial profit compared to the allowance method.

The exact amount of bad debt expense is known in the direct write off method whereas the allowance method is more of like an estimation of the amount. In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the accuracy of financial reports. The projected bad debt expense is properly matched against the related sale, thereby providing a more accurate view of revenue and expenses for a specific period of time. In addition, this accounting process prevents the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses.

The following entry should be done in accordance with your revenue and reporting cycles recording the expense in the same reporting period as the revenue is earned , but at a minimum, annually. These percentages are multiplied by total sales in each customer category, then the resulting three separate dollar amounts are added up and converted to a percentage based on the total sales amount.

As well, customers in any risk category can change their behavior and start or stop paying their invoices. This is where a company will calculate the allowance for doubtful accounts based on defaults in the past. To do this, a company should go back five years, and figure out for every year the percentage of unpaid accounts.

They can do this by looking at the total sales amounts for each year, and total unpaid invoices. An average can be created from that, in percentage form. Now the company looks at total sales from this year.

They multiply it by the percentage. The resulting figure is the new allowance for doubtful accounts number. The doubtful account balance is a result of a combination of the above two methods. It can be done as follows:. Allowance for doubtful accounts do not get closed, in fact the balances carry forward to the next year. You can unsubscribe at any time by contacting us at help freshbooks.