What Is Allowance for Doubtful Accounts
An allowance for doubtful accounts is a general ledger account used to record potential bad debts. The reason you use the account is the matching principle. This principle refers to recording expenses in the same time period as the revenue earned as a result of the expenses. The accrual method of accounting requires you to record expenses in the same period that you earned the revenue. By using an allowance for doubtful accounts, you guess which receivables you don’t expect to collect, record an expense for these bad debts, and reduce the carrying value of receivables. Without the use of the allowance for doubtful accounts general ledger account, you record revenue in one period and the write-off of uncollectible accounts is likely recorded in a different period.
How to Record Allowance of Doubtful Accounts
You calculate the allowance for doubtful accounts using either the balance sheet method with an accounts receivable aging schedule or the income statement method. Accounts receivable aging schedules contain a list of how much money customers owe you and how long they’ve owed the debt. This helps you follow up with clients to receive payments.
In all cases, you record a debit to an expense typically named a bad debt expense. This is a debt you’re not able to collect from a customer, and this situation often occurs when you deliver services or goods before receiving payment. In your ledger, the credit to allowance for doubtful accounts increases the value of the contra asset account. This is a type of general ledger account designed to have the balance be the opposite of the normal balance for that account classification. Allowance for doubtful accounts is a contra asset account that’s associated with the accounts receivable asset account. A contra asset is a type of general ledger account that reduces the value of an asset. In this case, the net accounts receivable balance decreases by the allowance for doubtful accounts.
Allowance of Doubtful Accounts Example
Say your client has $10,000 of outstanding receivables and you establish an allowance for doubtful accounts for $800, the carrying value of net receivables is $9,200. In the same period, you record the $10,000 of revenue, plus you record $800 of bad debt expense. Because of the allowance for doubtful accounts, the amount your client expects to receive, or $9,200, matches the net profit you report. Always show this allowance as a separate line from accounts receivable. In this case, both the accounts receivable of $10,000 and allowance of $800 appear on your client’s balance sheet. Following these rules makes financial statements correct according to accrual accounting principles.
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