The allowance is established in the same accounting period as the original sale, with an offset to bad debt expense. The percentage of sales method and the accounts receivable aging method are the two most common ways to estimate uncollectible accounts. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
Related Terms Bad Debt Definition Bad debt is an expense that a business incurs once the repayment of credit previously extended to a customer is estimated to be uncollectible. Bad Debt Expense Definition Bad debt expense is an expense that a business incurs once the repayment of credit previously extended to a customer is estimated to be uncollectible.
Contra Account Definition A contra account is an account used in a general ledger to reduce the value of a related account. A contra account's natural balance is the opposite of the associated account. Accounts Receivable Aging Definition Accounts receivable aging is a report categorizing a company's accounts receivable according to the length of time an invoice has been outstanding.
Partner Links. Related Articles. Accounting When is revenue recognized under accrual accounting? For detailed expectations and guidelines related to write offs, see W riting Off Uncollectable Receivables.
Use: Use with approval from the Division of Financial Affairs only. When the allowance object code is used, the unit is anticipating that some accounts will be uncollectible in advance of knowing the specific amount. ABC reverses the account by entering:. It alters the accounts receivable in the balance sheet to reflect this. Their balance sheet will appear as:. To monitor bad debt and follow-up on payments owed, businesses create journal entries for the allowance of doubtful accounts.
In the journal entry, it debits bad debt expenses while crediting the amount it expects to be paid. When a doubtful debt turns into bad debt, businesses credit their account receivable and debit the allowance for doubtful accounts.
However, the customers sometimes pay the amount written off as bad debts. When this happens, the balance sheet manager reverses the account by debiting the accounts receivable. In a balance sheet, companies place the allowance of doubtful accounts section under assets.
It's slotted directly below the accounts receivable item, which implies this is the amount of money the company expects to receive. Any amount added as allowance of doubtful accounts is a deduction allowing the company to have visibility of the extent of bad debt.
For example, Company ABC from the previous examples might place allowance for doubtful accounts in the balance sheet like:. Bad debt refers to a debt you've officially accepted as being left unpaid by the customer. It's money you thought your company would receive, but it remains uncollectible. Payments that remain unpaid turn into bad debts. A doubtful debt remains collectible, but a business doesn't expect to receive payment for it. There's still a chance your company may receive payment, but you're predicting it eventually turns into bad debt.
Business professionals who provide lines of credit to their clients establish allowance for doubtful accounts to improve the accuracy of accounts receivable in the balance sheet. Accountants, business owners and managers use allowance for doubtful accounts to estimate payments that might remain unpaid. 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.
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. There are a variety of allowance methods that can be used to estimate the allowance for doubtful accounts.
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. Perhaps the most effective method, the historical percentage uses past bad debt totals to predict your ADA for the current year. 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.
The calculation to determine the ADA would be:. 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. Remember that the allowance for doubtful accounts is just an estimate. This entry permanently reduces the accounts receivable balance in your general ledger, while also reducing the allowance for doubtful accounts.
You can do so with the following journal entry:. The first journal entry reduces the allowance for doubtful accounts while increasing your accounts receivable balance. 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. Are you paying more in taxes than you need to? Every dollar makes a difference, and you can save more of them by taking ALL the tax deductions available to your business.
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