Allowance for doubtful accounts

December 23, 2018

The allowance for doubtful accounts is paired with and offsets accounts receivable. The allowance
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.

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.

For example, 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.