An allowance for doubtful accounts is a contra-asset 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 is only an estimate of the amount of accounts receivable which are
expected to not be collectible. The actual payment behavior of customers may differ substantially from
the estimate.

KEY TAKEAWAYS

 The allowance for doubtful accounts is a contra-asset account that records the amount of
receivables expected to be uncollectible.

 The allowance is established in the same accounting period as the original sale, with an offset to
bad debt expense.

 The percentage of sales method and the accounts receivable aging method are the two common
ways to estimate uncollectible accounts.

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Allowance for Doubtful Accounts

Understanding the Allowance For Doubtful Accounts

The allowance is established by recognizing bad debt expense on the income statement in the same

period as the associated sale is reported. Only entities that extend credit to their customers use an
allowance for doubtful accounts. Regardless 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 account 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.

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 still be
established in the same accounting period as the sale but can be based on an anticipated and estimated
figure. The allowance can accumulate across accounting periods and may be adjusted based on the
balance in the account. Two primary methods exist for estimating the dollar amount of accounts
receivables not expected to be collected.

Recording the Allowance for Doubtful Accounts

Percentage of Sales Method

The 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 Method

The 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 groups 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 not be collectible and 4% of 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.