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. The accrual method of accounting requires you to record expenses in the same period the revenue is earned. By using an allowance for doubtful accounts, you guess which receivables won’t be collected, 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, revenue is recorded in one period and the write-off of uncollectible accounts is more likely recorded in a different period.
An allowance for doubtful accounts is calculated using either the balance sheet method with an accounts receivable aging schedule or the income statement method. In all cases, you record a debit to an expense typically named a bad debt expense. In the journal entry, the credit to allowance for doubtful accounts increases the value of the contra asset account. A contra asset is a type of account that reduces the value of an asset. In this case, the net accounts receivable balance is reduced by the allowance for doubtful accounts.
If 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 recorded the $10,000 of revenue, you also 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 is reported on your client’s balance sheet. Following these rules makes financial statements correct according to accrual accounting principles.