The allowance for doubtful accounts is an estimate of money owed to your business that you won’t be able to collect from customers. If your business issues accrual basis financial statements, you should calculate an allowance for doubtful accounts and show it on your company’s balance sheet.
Keep reading to learn more about what an allowance for doubtful accounts is, how to calculate it, and where it belongs on your balance sheet.
Why Use an Allowance for Doubtful Accounts?
The allowance for doubtful accounts helps you see the true value of your assets. It estimates the amount of money you won’t be able to collect from customers any time soon, so you can figure out how much you’ll actually get in the bank.
How It Works
Your allowance for doubtful accounts uses a credit balance to partially offset the debit balance of an asset on your balance sheet. This is also known as a contra asset account.
Let’s go over an example so we can see it in action:
Say your accounts receivable balance (i.e., the amount owed to your business from customers) is $25,000 at the end of the year, but you estimate that roughly $2,500 of those receivables are uncollectible–either because customers declared bankruptcy, disputed the amount they owe, or simply didn’t pay their invoices.
Showing the full $25,000 of receivables as an asset on your balance sheet would be overstating your assets since it’s highly unlikely that you’ll be able to collect the total amount. So instead, your balance sheet would show the following:
Accounts Receivable $25,000
Allowance for Doubtful Accounts ($2,500)
How to Calculate the Allowance for Doubtful Accounts
There are three ways to calculate the allowance for doubtful accounts:
1. Percentage of Credit Sales
Under the percentage of credit sales method, you estimate your allowance for doubtful accounts based on the historical percentage of credit sales that aren’t collectible for your company or your industry.
For example, say over the past five years, 2% of your company’s credit sales haven’t been collectible. So each accounting period, you would enter 2% of that period’s credit sales as a debit to bad debt expense. You’d also add it as a credit to your allowance for doubtful accounts.
2. Accounts Receivable Aging
Under the accounts receivable aging method, you classify your accounts receivable into different age groups and estimate the percentage of each age group that will be uncollectible based on past experience. This method assumes that the longer a receivable is outstanding, the lower your chances of collecting the full amount.
For example, say you run an accounts receivable aging report at the end of the year and see the following:
- Due in 0 - 30 days: $10,000
- Due in 31 - 60 days: $25,000
- Due in 61 - 90 days: $5,000
- Due in 90+ days: $12,000
Based on your history:
- 1% of current (0 - 30 day) receivables are uncollectible
- 10% of 31-60 day receivables are uncollectible
- 15% of 61-90 day receivables are uncollectible, and
- 20% of 90+ day receivables are uncollectible
So you would calculate your allowance as follows:
1% of 0-30 day receivables + 10% of 31-60 day receivables + 15% of 61-90 day receivables + 20% of 90+ day receivables
($10,000 x .01) + ($25,000 x .10) + ($5,000 x .15) x ($12,000 x .20) = $100 + $2,500 + $750 + $2,400 = $5,750
At year-end, your allowance for doubtful accounts should be $5,750.
3. Customer Risk Classification
A third way to calculate the allowance for doubtful accounts is the customer risk classification method. For this method, you assign each customer a default risk percentage based on their payment history.
For example, say your accounts receivable balance is made up entirely of two customers:
- Customer A: $10,000
- Customer B: $20,000
Historically, Customer A doesn’t pay 1% of their outstanding invoices, and Customer B disputes 2% of their outstanding invoices, so you calculate your allowance as follows:
- Customer A: $10,000 x .01 = $100
- Customer B: $20,000 x .02 = $400
So your allowance for doubtful accounts would be $500.
This method works best for companies with a small number of customers who’ve been doing business with you for a while. For businesses with a large number of constantly changing clients, using the customer risk classification would be difficult because you wouldn’t have historical data on every client.
What is the Journal Entry for Uncollectible Accounts?
After calculating your allowance for doubtful accounts at the end of the accounting period, you make a journal entry to record the adjustment in your company’s books.
If this is your first time recording the allowance, you simply debit your bad debt expense account and credit your allowance account for the same amount. But what happens if your allowance for doubtful accounts already has an account balance? In that case, your adjusting entry will just be the difference between what’s currently on the books and the allowance amount.
For example, say on December 31, 2022, your allowance account shows a credit balance of $2,000. You calculate your allowance using the accounts receivable aging method shown above and decide your allowance should be $5,750.
In that case, you only need to increase your allowance by $3,750 ($5,750 - $2,000), so your journal entry for that period would be as follows:
Writing Off an Account
What happens when you discover that one of your receivables is actually uncollectible? At that point, you want to remove that account from your accounts receivable balance.
For example, say as of December 31, 2022, ABC Supply Co. owes you $500 for goods purchased on credit. Then, in February 2023, the CFO informs you that the company filed for bankruptcy and won’t be able to pay the amount they owe.
To write off ABC Supply Co.’s account balance, you need to remove that $500 from accounts receivable by crediting the A/R account and remove it from the allowance account with a debit. So you make the following journal entry:
Recovering a Receivable Account
Now, let’s say after you wrote off ABC Supply Co.’s balance, the company manages to pay the invoice after all. You need to make two journal entries: one to reinstate the written-off receivable and one to record the $500 payment.
To reverse the write-off, you debit accounts receivable and credit the allowance account to add the $500 back to your receivables. Essentially, you’re reversing the entry you made to write off the receivable in the prior example. So your entry would be:
Then, to record the payment from ABC Supply Co., you debit cash for the payment you received and credit accounts receivable to remove the receivable again. So your entry would be:
Who Needs to Use an Allowance for Doubtful Receivables?
Companies that issue financial statements prepared according to generally accepted accounting principles (GAAP) must use the allowance method.
Publicly traded companies are required to follow GAAP rules, so some small businesses follow GAAP if they plan on growing and potentially going public someday. Otherwise, they may elect to use an easier method, which we'll go into next.
Is There an Easier Method to Use?
Many business owners use an easier method to write off outstanding accounts that have become uncollectible. It's called the direct method, and if going public isn't part of your long-term plans, you may want to consider using it.
Under the direct method, you assume that your total receivables are collectible and show their full value with no contra account on the balance sheet. If you later realize that an invoice is uncollectible, you make a journal entry to write off that receivable.
Most small businesses use this method because it's easier to simply write off a receivable to bad debt expense when you know it’s uncollectible than it is to estimate an allowance.
For example, say ABC Supply Co. owes you $500 when they file for bankruptcy. If you use the direct write-off method, you don’t have an allowance for doubtful accounts. Your journal entry to remove the uncollectible amount just needs to debit bad debt expense and credit accounts receivable as follows:
Let’s Wrap It Up: Allowance for Doubtful Accounts Helps You Figure Out Cash Flow
An allowance for doubtful accounts helps you estimate the realizable value of your receivables and more accurately project cash flow and working capital. And while some uncollectible accounts are a part of doing business, bad debt hurts your bottom line. So you should do everything you can to avoid losing money on customers who don’t pay their invoices.
That might mean offering credit only to credit-worthy customers, following up with late-paying customers as soon as their accounts become overdue, and referring delinquent accounts to your attorney or a collection agency when necessary.
1. Introducing Yourself
Your introductory email needs to pack a lot of information into a small package. Try something like this:
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Hello Jane,
My name is John Doe and I work for ABC Agency, where we provide business insurance policies to many of Dallas' rockstar small businesses.
Congratulations on your new business, Jane's Bakery. Are you wondering if you have all the insurance you need? Or if your policies will really cover you in a pinch?
At ABC Agency, we pride ourselves on providing robust, comprehensive coverage options to companies like yours with flexible, pay-as-you-go plans.
Are you available this week to talk more about how we can help? I can help you find the most affordable rates and the best policies out there.
I look forward to speaking with you soon.
Cheers,
John Doe
2. Presenting a Quote
Once you've met with your potential client, a quick reply with their quote will get the ball rolling.
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Hi Jane,
Thanks so much for meeting with me this morning. I loved touring Jane's Bakery–I can still smell those delicious chocolate chip cookies baking! You have a great location, and I'm sure you're going to do great on Front St.
After reviewing my notes, I've pulled together an insurance quote for you (attached). I recommend a business owner's policy. A BOP includes several insurance products in one: liability, property insurance, and business interruption insurance. It offers robust coverage at a competitive price.
I'll call you in a few days to see what you think about this insurance plan. In the meantime, if you have any questions, don't hesitate to email me or call me at [phone number].
Again, thank you for your time today. I look forward to working with you in the future.
Cheers,
John Doe
3. Thanks for Purchasing a Policy
Gratitude is important! It's never a bad idea to thank your clients for their business.
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Hi Jane,
Thank you for choosing a business owner's policy with ABC Agency. We know it's so important to get the right coverage for your business, and we are honoured you've placed your trust in us.
We're excited to work closely with you, and our no. 1 goal is to make sure you're business is always protected.
Do you have any questions? We are here to help. Reach out whenever something comes to mind.
Thank you again for choosing ABC Agency to insure Jane's Bakery.
Cheers,
John Doe
4. Welcome Email
A welcome email helps clients feel like you're there to help–and can softly pitch other insurance products you offer.
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Dear Jane,
Welcome to the ABC family! We are thrilled to have you as a new customer and can't wait to meet all of your insurance needs.
As an independent insurance agency, we work with multiple insurance providers to find the best coverage options for all our customers. If you need any other type of insurance–like [include additional offerings unique to your agency, like life insurance, health insurance, home insurance or anything else]–we can help you too.
Do you want to discuss any of these policies?
Cheers,
John Doe
5. Introducing a New Product
A happy client may want to expand their business with you.
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Hello Jane,
I hope all is well with you and Jane's Bakery. I stopped in yesterday for a blueberry muffin and coffee, and they were delicious. I loved the hint of cinnamon in the muffin! Was that your idea?
I wanted you to be the first to know we are now offering commercial vehicle insurance to our policyholders. Auto insurance for your catering vans is super important since your personal car insurance won't cover them.
We're offering this insurance coverage solely to our current business clients at the moment and have some very competitive rates.
Would you like me to work up a quote for you?
As always, thanks so much for being a part of the ABC family.
Cheers,
John Doe
6. Asking For Referrals
Once your relationship is established and comfortable, let your clients help you grow.
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Hi Jane,
You've been a valuable member of the ABC family for two years now, and we so appreciate your business–not to mention the muffins you supply for our monthly meetings!
Because you are a valued policyholder, I wanted to ask a quick favour. I know you are active in the local Chamber of Commerce, and I'm hoping you might know some colleagues who would benefit from working with our insurance company.
Referrals are one of the most effective ways to connect with our community since people really trust their friends, family and colleagues. Is there anyone you'd recommend I speak with?
Remember that in addition to business insurance products, we offer everything from life insurance policies to pet insurance.
As a thank you for your help, we will send you an Amazon gift card of $100 when your referrals buy insurance from us.
Thanks so much for your help!
Cheers,
John Doe
7. Policy Renewal
If your client needs to renew their policy with you, send an email like this:
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Hi Jane,
I hope you're doing well! What a year it's been—from being listed as one of the top 5 bakeries in Dallas to being an official vendor for the city—you have so much to be proud of.
Just a heads up that your business owner's policy is up for renewal soon and will expire on June 15, 2023.
If you're still happy with the coverage, we can easily renew it for you.
Do you have some time to chat this week?
Looking forward to serving you again!
Cheers,
John Doe