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.