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Allowance for Doubtful Accounts

Guide to Understanding the Allowance for Doubtful Accounts

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Allowance for Doubtful Accounts

Allowance for Doubtful Accounts: Balance Sheet Accounting

The allowance for doubtful accounts (or the “bad debt” reserve) appears on the balance sheet to anticipate credit sales where the customer cannot fulfill their payment obligations.

Credit sales all come with some degree of risk that the customer might not hold up their end of the transaction (i.e. when cash payments left unmet).

In accordance with GAAP revenue recognition policies, the company must still record credit sales (i.e. not cash) as revenue on the income statement and accounts receivable on the balance sheet.

The allowance for doubtful accounts is then used to approximate the percentage of “uncollectible” accounts receivable (A/R).

Allowance for Doubtful Accounts: Contra-Asset Classification

The allowance for doubtful accounts is management’s objective estimate of their company’s receivables that are unlikely to be paid by customers.

On the balance sheet, an allowance for doubtful accounts is considered a “contra-asset” because an increase reduces the accounts receivable (A/R) account.

  • Contra-Asset → Negative Asset Account to Offset the Coinciding Asset’s Balance

The allowance reserve is set in the period in which the revenue was “earned,” but the estimation occurs before the actual transactions and customers can be identified.

The actual payment behavior of customers, or lack thereof, can differ from management estimates, but management’s predictions should improve over time as more data is collected.

GAAP allows for this provision to mitigate the risk of volatility in share price movements caused by sudden changes on the balance sheet, which is the A/R balance in this context.

Matching Principle: Bad Debt and Revenue

The projected bad debt expense is matched to the same period as the sale itself so that a more accurate portrayal of revenue and expenses is recorded on financial statements.

In effect, the allowance for doubtful accounts leads to the A/R balance recorded on the balance sheet to reflect a value closer to reality.

Otherwise, it could be misleading to investors who might falsely assume the entire A/R balance recorded will eventually be received in cash (i.e. bad debt expense acts as a “cushion” for losses).

Allowance Method: Journal Entries (Debit and Credit)

The allowance method estimates the “bad debt” expense near the end of a period and relies on adjusting entries to write off certain customer accounts determined as uncollectable.

  • Accounts Receivable (A/R): The total dollar amount of unmet cash payments from customers that paid on credit for revenue already “earned.”
  • Allowance for Doubtful Accounts: The amount of accounts receivable (A/R) estimated to be later written off as uncollectible.

The most prevalent approach — called the “percent of sales method” — uses a pre-determined percentage of total sales assumption to forecast the uncollectible credit sales.

Management projects the amount of bad debt by referencing historical data such as the following:

  • Frequency of Past Uncollectible A/R
  • Age of Current A/R Balances

The journal entries for recording the uncollectible A/R are as follows:

  • Bad Debt Expense → Debit
  • Allowance for Doubtful Accounts → Credit

Note that the accounts receivable (A/R) account is NOT credited, but rather the allowance account for doubtful accounts, which indirectly reduces A/R.

Most balance sheets report them separately by showing the gross A/R balance and then subtracting the allowance for doubtful accounts balance, resulting in the “Accounts Receivable, net” line item.

  • Accounts Receivable, net = Accounts Receivable, gross – Allowance for Doubtful Accounts

Microsoft Allowance for Doubtful Accounts Example

“The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence”

Microsoft Allowance for Doubtful Accounts

 

Allowance for Doubtful Accounts Schedule (Source: MSFT 10-K)

Direct Write-Off Method

The write-off method violates the matching principle under U.S. GAAP since the expense is recognized in a different period as when the revenue was earned.

Moreover, using the direct write-off method is prohibited for reporting purposes if the company’s business model is characterized by a significant amount of credit sales (i.e. paid on credit) with large A/R balances.

But if the company’s total revenue is primarily from cash sales rather than credit sales, and the receivables balance is minimal — the company could potentially opt to use the direct write-off method when calculating the expense pending approval.

Allowance for Doubtful Accounts Journal Entry Example

Suppose a company generated $1 million of credit sales in Year 1 but projects that 5% of those sales are very likely to be uncollectible based on historical experience.

  • Estimated Bad Debt = $1 million × 5% = $50,000

Given the $50,000 of projected bad debts, the accounting journal entries at the end of Year 1 are as follows:

  • Bad Debt Expense: Debited $50,000
  • Allowance for Doubtful Accounts: Credited $50,000
Adjusting Entry Debit Credit
Bad Debt Expense $50,000
      Allowance for Doubtful Accounts $50,000

The bad debt expense is entered as a debit to increase the expense, whereas the allowance for doubtful accounts is a credit to increase the contra-asset balance.

As companies report their financial statements near the end of the fiscal period, adjusting entries are necessary to arrive at the “Accounts Receivable, net” balance and recognize a “Bad Debt” expense in the corresponding period.

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