ALLOWANCE FOR

DOUBTFUL ACCOUNTS:
METHODS OF ACCOUNTING FOR DOUBTFUL ACCOUNTS

WHAT IS AN ALLOWANCE FOR DOUBTFUL ACCOUNTS?
• An allowance for doubtful accounts is a 
contra asset account that is used to create an
allowance for clients that purchase goods or
services and then fail to pay the amount owed for
their purchases.
• An AFDA reduces the total amount of 
accounts receivable on a business's balance sheet
 to more appropriately reflect the amount of
money it can collect. The allowance for doubtful
accounts estimates the percentage of 
accounts receivable that are expected to be
uncollectible.
• Regardless of company policies and
procedures for credit collections, the risk
of the failure to receive payment is
always present in a transaction utilizing TO UNDERSTAND THE
credit.
ALLOWANCE FOR DOUBTFUL
Thus, a company is required to realize ACCOUNTS …
this risk through the establishment of
the allowance for doubtful accounts and
offsetting bad debt expense.
 PURPOSE OF AFDA
The purpose of the allowance is to use
the matching principle between revenue
and expenses while also reporting the net
amount of assets using the conservatism
principle.
The purpose of the allowance for doubtful
accounts is to estimate how many
customers out of the 100 will not pay the
full amount they owe. Rather than waiting
to see exactly how payments work out,
the company will debit a bad debt
expense and credit allowance for doubtful
accounts.
BUT MOSTLY IMPORTANT…
COMPANIES TECHNICALLY DON'T NEED TO HAVE AN
ALLOWANCE FOR DOUBTFUL ACCOUNT. IF IT DOES NOT
ISSUE CREDIT SALES, REQUIRES COLLATERAL, OR ONLY USES
THE HIGHEST CREDIT CUSTOMERS, THE COMPANY MAY
NOT NEED TO ESTIMATE UNCOLLECTABILITY.
PERCENTAGE OF SALES METHOD
This method calculates the allowance for doubtful accounts by administering a flat percentage to the
total amount of accounts receivable for the period.
For example, if the average bad debt for Company ABC for the first quarter is $20,000, and the
company makes sales worth $500,000, then bad debt expense is 4% of sales. The company uses this
percentage to estimate the amount of bad debt based on sales in a particular period.
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 (AT THE SAME TIME) 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
All outstanding accounts receivable are grouped by age, and specific percentages are applied to
each group. The aggregate of all group 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 be uncollectible, and 4% of those 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.
This can help your planning and budgeting processes.
 RISK CLASSIFICATION METHOD
Some companies may classify different types of debt or different types of vendors using risk
classifications.
For example, a start-up customer may be considered a high risk, while an established,
long-tenured customer may be a low risk. In this example, the company often assigns a
percentage to each classification of debt. Then, it aggregates all receivables in each grouping,
calculates each group by the percentage, and records an allowance equal to the aggregate of
all products.
With this method, assign each customer a risk score about the likelihood of them leaving
debts unpaid. Customers with a higher risk of defaulting on their credit will receive a higher
score.
For example, Company ABC can group customers into three risk categories, such as low,
medium and high, based on their likelihood of default. The percentage of each category
relative to the total amount owed can give the company an estimate for allowance for
doubtful accounts.
HISTORICAL PERCENTAGE METHOD
If a company has a history of recording or tracking bad debt, it
can use the historical percentage of bad debt if it feels that
historical measurement relates to its current debt. For example,
a company may know that its 10-year average of bad debt is
2.4%. Therefore, it can assign this fixed percentage to its total
accounts receivable balance since more often than not, it will
approximately be close to this amount. The company must be
aware of outliers or special circumstances that may have unfairly
impacted that 2.4% calculation.