Allowance for doubtful accounts debit or credit
An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible. However, the actual payment behavior of customers may differ substantially from the estimate. Show
Key Takeaways
1:22 Allowance for Doubtful AccountsUnderstanding the Allowance for Doubtful AccountsRegardless of company policies and procedures for credit collections, the risk of the failure to receive payment is always present in a transaction utilizing credit. Thus, a company is required to realize this risk through the establishment of the allowance for doubtful accounts and offsetting bad debt expense. In accordance with the matching principle of accounting, this ensures that expenses related to the sale are recorded in the same accounting period as the revenue is earned. The allowance for doubtful accounts also helps companies more accurately estimate the actual value of their account receivables. Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity does not know for certain which exact receivables will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure. The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account. Recording the Allowance for Doubtful AccountsTwo primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected. Percentage of Sales MethodThe sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense. If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400. Accounts Receivable Aging MethodThe second method of estimating the allowance for doubtful accounts is the aging method. All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group. The aggregate of all group results is the estimated uncollectible amount. For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and 4% of those accounts receivable at least 30 days old will be uncollectible. Therefore, the company will report an allowance of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 - $1,900) will be the adjusting entry amount. accounting, accounts receivable, allowance for uncollectible accounts, bad debt, balance sheet, contra-asset accountSee also: Allowance for Uncollectible Accounts DefinitionAllowance for uncollectible accounts is a contra asset account on the balance sheet representing accounts receivable the company does not expect to collect. When customers buy products on credit and then don’t pay their bills, the selling company must write-off the unpaid bill as uncollectible. Allowance for uncollectible accounts is also referred to as allowance for doubtful accounts, and may be expensed as bad debt expense or uncollectible accounts expense. Allowance for Doubtful Accounts: CalculationFinding the proper amount for the allowance for doubtful accounts is not an instant process. More, it is developed over years of operations. To create a standard allowance, have those financial records that indicate how many accounts have not been collected. Then, compare these figures to historical measurements. Then create an average amount of money lost over the number of years measured. This creates historical averages. Once done, a company can compare these to the records of other companies or industry statistics. The company can use this information to attempt to bring this amount to an equal level, as compared to common industry best practices. Allowance for Doubtful Accounts: Normal BalanceBecause the allowance for doubtful accounts account is a contra asset account, the allowance for doubtful accounts normal balance is a credit balance. So for an allowance for doubtful accounts journal entry, credit entries increase the amount in this account and debits decrease the amount in this account. The allowance for doubtful accounts account is listed on the asset side of the balance sheet, but it has a normal credit balance because it is a contra asset account, not a normal asset account. [box]Strategic CFO Lab Member Extra Access your Cash Flow Tune-Up Tool Execution Plan in SCFO Lab. The step-by-step plan to get ahead of your cash flow. Click here to access your Execution Plan. Not a Lab Member? ARTICLES YOU MIGHT LIKE July 28, 2020 See also: Quick Ratio Analysis Price to Book Value Analysis Price Earnings Growth Ratio Analysis Time Interest Earned Ratio Analysis Use of Financial Ratios Financial Ratios are used to measure financial performance against standards. Analysts compare financial ratios to industry averages (benchmarking), industry standards or rules of thumbs and against internal trends (trends analysis). 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The markup sales are expressed as a percentage increase as to try and ensure that a company can receive the proper Why is allowance for doubtful accounts a debit?The purpose of the allowance for doubtful accounts is to estimate how many customers out of the 100 will not pay the full amount they owe. Rather than waiting to see exactly how payments work out, the company will debit a bad debt expense and credit allowance for doubtful accounts.
What type of account is allowance for doubtful accounts?An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable. The allowance, sometimes called a bad debt reserve, represents management's estimate of the amount of accounts receivable that will not be paid by customers.
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