What is allowance for doubtful accounts?
Question by Ellie: What is allowance for doubtful accounts?
Okay, I can’t really get it in my head. I know that Bad debt expense is the expense where people might not pay from accounts receivable, but I don’t really understand the “allowance for doubtful” account. What affects it?
Best answer:
Answer by Nora C
The Allowance for Doubtful Accounts is a contra asset account that goes along with the Accounts Receivable account on the balance sheet. They are often presented on a net basis, with the allowance noted on the face of the statements. When a company does not require payment up front for goods and services they are aware that it is unlikely that they will collect 100% of the amount of credit that they extend to customers. Therefore they will establish an “Allowance” or “reserve” for the amount that they do not expect to collect. This can be done in several different fashions (taking a % of overall receivables, or specifically reserving for accounts that are known to be troubled, or a combination of those two approaches). The dollar amount and timing of establishing the allowance/ reserve is very judgmental, so is often subject to extra scrutiny by auditors as it is one place that management can easily manipulate earnings. Once the amount is established they will debit the Bad Debt Expense account and credit the Allowance for Doubtful Accounts account. Then as time passes and specific accounts are deemed to be uncollectible they are written off by debiting the Allowance account and crediting the customer’s receivable balance. This overall approach to handling accounts receivable is known as the indirect method, and is what is used by most all businesses because it better matches expenses to the period when they were actually incurred. However, it is not uncommon for small business that do not have strict reporting requirements to use the direct method of accounting for accounts receivable, where they do not use an Allowance account, but rather credit accounts receivable and debit bad debt expense when they determine that a debt is uncollectible.
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October 29th, 2010 at 4:36 am
simply put, the Allowance for Doubtful accounts is the amount of bad debt expense that a company estimates they MIGHT not be able to collect. Bad Debt Expense is the ACTUAL amount of money the company had to write off because it was uncollectible.
You state the bad debt expense is where people MIGHT NOT pay….but bad debt expense is the actual amount that was written off. The allow. for doubt. accts is the amount where people might not pay.
Companies know that a certain percentage of their customers won’t pay their bills. Therefore they will estimate this and show it on their balance sheet as an allowance (or reserve). Otherwise if someone were looking at their a/r balance sheet figure and saw $ 1,000,000 in A/R they might assume that the company is going to collect $ 1M eventually. But if the company knows that only 70% of this will be collected then it misrepresents the A/R figure. Therefore they’ll create an allow. for doubt. of $ 300,000 and show this on the balance sheet as well. Then investors will understand that while the company is owed $ 1M, they only expect to collect $ 700K of it and may have to write off $ 300K of it.