Doubtful accounts are past-due invoices that your business does not expect to actually collect on before the end of the accounting period. In other words, doubtful accounts are an estimated percentage of accounts receivable that aren’t likely to ever hit your bank account. After a certain period of time going uncollected, a doubtful account can become a bad debt, which is ultimately a cost that’s absorbed by your business.
In order to generate more accurate financial statements with this in mind, accounting teams often rely on something called an “allowance for doubtful accounts.” The allowance for doubtful accounts is also known as ADA or a bad debt reserve. This amount allows your organization to plan for uncollectible debts that impact your bottom line and budget.
In this post, we explain the importance of ADA, how to calculate it, where to record it, and more. Read on for a full breakdown on the topic, or use the links below to navigate to the subtopic that best answers your query.
- What is the allowance for doubtful accounts?
- What is a bad debt expense?
- Why is the allowance for doubtful accounts important?
- How to use the allowance for doubtful accounts
- How to record the allowance for doubtful accounts journal entry
- What is a reasonable allowance for doubtful accounts?
The allowance for doubtful accounts is an estimate of the portion of accounts receivable that your business does not expect to collect during a given accounting period. Accounting teams build in these estimated losses so they can prepare more accurate financial statements and get a better idea of important metrics, like cash flow, working capital, and net income.
Also known as “bad debts,” these outstanding accounts typically originate from credit sales that are never settled by customers. Unfortunately, this is an inherent risk of extending credit to your customers. The allowance for doubtful accounts is recorded as a line item on a company’s balance sheet. We’ll show you how to record ADA later on in this post.
It’s important to note that an allowance for doubtful accounts is simply an informed guess and your customers’ payment behaviors may not exactly align. This could mean more customers fail to pay and you wind up with more uncollectible accounts, or you might have overestimated your allowance for doubtful accounts.
What type of account is the allowance for doubtful accounts?
An allowance for doubtful accounts is also referred to as a contra asset, because it’s either valued at zero or it has a credit balance. In this context, the contra asset would be deducted from your accounts receivable assets and would be considered a write-off.
Bad debts expense is when a company deems an outstanding account “uncollectible” because the customer cannot settle the debt due to bankruptcy or other financial complications. After an amount is considered not collectible, the amount can be recorded as a write-off. This means the business credits accounts receivable and debits the bad debt expense.
The allowance for doubtful accounts is important because it helps your accounting and bookkeeping teams generate more accurate financial statements that present a realistic view of your current assets. With these materials, you’ll be able to better prepare and plan for your business’ financial future.
Unfortunately, unpaid invoices are a pretty common problem for small businesses in the U.S. In fact, the total amount of unpaid invoices is approximately $825 billion, equivalent to about 5% of the U.S. GDP. QuickBooks research also shows nearly half (44%) of small business owners who experience cash flow issues say the problems were a surprise. Including an allowance for doubtful accounts in your accounting can help you plan ahead and avoid cash flow problems when payments don’t come in as expected.
To use the allowance for doubtful accounts, choose a method for calculating your company’s ADA. There are two main methods for estimating your allowance for doubtful accounts:
- The accounts receivable aging method
- The percentage of sales method
The accounts receivable aging method uses your company’s accounts receivable aging report to determine the bad debt allowance. In the percentage of sales method, the business uses only one percentage to determine the balance of the allowance for doubtful accounts.
How the accounts receivable aging method works
The accounts receivable aging method uses receivables aging reports to keep track of invoices that are past due. Using historical data from an aging schedule can help you predict whether or not an invoice will be paid.
For example, if 3% of invoices that are 90 days past due are considered uncollectible, you can assume that 97% of the invoices in this age group will be paid. As a general rule, the longer a bill goes uncollected past its due date, the less likely it is to be paid.
How the percentage of sales method works
The percentage of sales strategy assigns a flat rate to each accounting period’s total sales. Let’s consider an example: Using previous invoicing data, the accounting team estimates that 4% of net income will be considered uncollectible. So, if the team assumes they’ll earn $100,000 in net sales but they estimate that 4% of invoices will be uncollectible, they can budget $4,000 in bad debt expenses.
The allowance for doubtful accounts is recorded as a contra asset account under the accounts receivable on a company’s balance sheet. If you use the accrual basis of accounting, you will record doubtful accounts in the same accounting period as the original credit sale. This will help present a more realistic picture of the accounts receivable amounts you expect to collect, versus what goes under the allowance for doubtful accounts.
To record a journal entry for an allowance for doubtful accounts:
- Debit the expense as a Bad Debt Expense account on your income statement.
- Credit the allowance for Doubtful Accounts on your balance sheet.
Ideally, you’d want 100% of your invoices paid, but unfortunately, it doesn’t always work out that way. According to recent research by Dun & Bradstreet, publishing, commercial printing, and prepackaged software providers are among the industries most likely to report uncollectible invoices.
Assuming some of your customer credit balances will go unpaid, how do you determine what is a reasonable allowance for doubtful accounts? It depends on your business, customers, and industry. The aging method and percentage of sales methods described above can help you use historical data to determine the amount of accounts receivable you’ll likely get fulfilled and how much may be classified as doubtful debts.
With QuickBooks accounting software, you can access important insights, like your allowance for doubtful accounts. With this data at the ready, you can more efficiently plan for your business’ future, keep track of paid and unpaid customer invoices, and even automate friendly payment reminders when needed, all in one place.
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