Allowance for doubtful accounts definition
/What is the Allowance for Doubtful Accounts?
The allowance for doubtful accounts is paired with and offsets accounts receivable . It represents management’s best estimate of the amount of accounts receivable that will not be paid by customers . When the allowance is subtracted from accounts receivable, the remainder is the total amount of receivables that a business actually expects to collect. Actual results may vary from management’s expectations for accounts receivable collections.
If a company is using the accrual basis of accounting , it should record an allowance for doubtful accounts, since it provides an estimate of future bad debts that improves the accuracy of the company’s financial statements . Also, by recording the allowance for doubtful accounts at the same time it records a sale, a company is properly matching the projected bad debt expense against the related sale in the same period, which provides an accurate view of the true profitability of a sale. In the firm's balance sheet , the allowance appears as a contra account that is paired with and offsets the accounts receivable line item.
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Example of the Allowance for Doubtful Accounts
A company records $10,000,000 of sales to several hundred customers, and projects (based on historical experience) that it will incur 1% of this amount as bad debts, though it does not know exactly which customers will default . It records the 1% of projected bad debts as a $100,000 debit to the Bad Debt Expense account and a $100,000 credit to the Allowance for Doubtful Accounts. The Bad Debt Expense is charged to expense right away, and the Allowance for Doubtful Accounts becomes a reserve account that offsets the account receivable of $10,000,000 (for a net receivable outstanding of $9,900,000).
Later, several customers default on payments totaling $40,000. Accordingly, the company credits the accounts receivable account by $40,000 to reduce the amount of outstanding accounts receivable, and debits the Allowance for Doubtful Accounts by $40,000. This entry reduces the balance in the allowance account to $60,000. The entry does not impact earnings in the current period.