Allowance for doubtful accounts: Methods & calculations

While collecting all the money you’re owed is the best-case scenario, small business owners know that things don’t always go as planned. Estimating invoices you won’t be able to collect will help you prepare more accurate financial statements and better understand important metrics like cash flow, working capital, and net income.

In particular, your allowance for doubtful accounts includes past-due invoices that your business does not expect to collect before the end of the accounting period. In other words, doubtful accounts, also known as bad debts, are an estimated percentage of accounts receivable that might never hit your bank account. 

Let’s explore the importance of allowance for doubtful accounts, the methods of estimating it, and how to record it. 

Methods for estimating allowance for doubtful accounts

The allowance for doubtful accounts, aka bad debt reserves, is recorded as a contra asset account under the accounts receivable account on a company’s balance sheet. It’s a contra asset because it’s either valued at zero or has a credit balance. In this context, the contra asset would be deducted from your accounts receivable assets and considered a write-off.

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.

There are five key methods for estimating the allowance. Let’s look at how to calculate allowance for doubtful accounts and how it can provide a more accurate picture of a company's financial position: 

Percentage of sales method

The percentage of sales method assigns a flat rate to each accounting period’s total sales. Using previous invoicing data, your accounting team will estimate what percentage of credit sales will be uncollectible. 

For example, a jewelry store earns $100,000 in net sales, but they estimate that 4% of the invoices will be uncollectible. The company’s allowance for doubtful accounts is $4,000. 

Accounts receivable aging method 

The accounts receivable aging method uses accounts receivable aging reports to keep track of past due invoices. Using historical data from an aging schedule can help you predict whether or not you’ll receive an invoice payment.

For example, our jewelry store assumes 25% of invoices that are 90 days past due are considered uncollectible. They assume that 75% of the invoices in this age group will be paid. Say it has $10,000 in unpaid invoices that are 90 days past due—its allowance for doubtful accounts for those invoices would be $2,500, or $10,000 x 25%.

Risk classification method

The risk classification method involves assigning a risk score or risk category to each customer based on criteria—such as payment history, credit score, and industry. The company then uses the historical percentage of uncollectible accounts for each risk category to estimate the allowance for doubtful accounts.

To use the risk classification method:

1. Assign a risk score or category to each customer.
2. Determine the historical percentage of uncollectible accounts for each category.
3. Multiply the accounts receivable amount for each category by the historical percentage.
4. Add up the estimated allowances for each category.

For example, our jewelry store may assign a customer a risk category of C. That category has a historical percentage of uncollectible accounts of 10%. The customer has $5,000 in unpaid invoices, so its allowance for doubtful accounts is $500, or $5,000 x 10%.

Pareto analysis method

The Pareto analysis method relies on the Pareto principle, which states that 20% of the customers cause 80% of the payment problems. By analyzing each customer’s payment history, businesses allocate an appropriate risk score—categorizing each customer into a high-risk or low-risk group. Once the categorization is complete, businesses can estimate each group's historical bad debt percentage. 

For example, our jewelry store has 1,000 customers:

• We determine 200 customers are high-risk and 800 are low-risk.
• The historical bad debt percentage for the high-risk group is 5% and 1% for the low-risk group. 
• The outstanding balance for the high-risk group is $500,000, and $1,500,000 for the low-risk group.

As a result, the estimated allowance for doubtful accounts for the high-risk group is $25,000 ($500,000 x 5%), while it’s $15,000 ($1,500,000 x 1%) for the low-risk group. Thus, the total allowance for doubtful accounts is $40,000 ($25,000 + $15,000). 

Specific identification method

The specific identification method allows a company to pick specific customers that it expects not to pay. In this case, our jewelry store would use its judgment to assess which accounts might go uncollected. 

For example, it has 100 customers, but after assessing its aging report decides that 10 will go uncollected. The balance for those accounts is $4,000, which it records as an allowance for doubtful accounts on the balance sheet. 

How do you record allowance for doubtful accounts

When a business makes credit sales, there’s a chance that some of its customers won’t pay their bills—resulting in uncollectible debts. To account for this possibility, businesses create an allowance for doubtful accounts, which serves as a reserve to cover potential losses. 

Creating this allowance ensures that the financial statements reflect a more accurate picture of the company's financial position and performance. The allowance provides a cushion against potential losses arising from bad debts, which may otherwise significantly impact the company's cash flow and profitability. When recording an allowance for doubtful accounts, here are the four steps to follow: 

1. Create allowance for doubtful accounts  

Companies create an allowance for doubtful accounts to recognize the possibility of uncollectible debts and to comply with the matching principle of accounting. After figuring out which method you’ll use, you can create the account in the chart of accounts.

The accounting journal entry to create the allowance for doubtful accounts involves debiting the bad debt expense account and crediting the allowance for doubtful accounts account.

2. Adjust allowance for doubtful accounts 

After creating an allowance for doubtful accounts, it is important for companies to regularly review and adjust this account to ensure that it accurately reflects the current state of their working capital and accounts receivable.

The adjustment process involves analyzing the current accounts, assessing their collectibility, and updating the allowance accordingly.

The adjustment process often involves two steps:

1. An evaluation of the accounts: This step involves looking at all the accounts receivable, assessing the collectibility of each account, and determining the amount of allowance necessary to cover the estimated bad debts.
2. An adjustment of the allowance: The next step involves updating the allowance account—either upward or downward—to reflect the estimated uncollectible amount.

Adjusting the allowance for doubtful accounts is important in maintaining accurate financial statements and assessing financial risk.

3. Write off an account

When assessing accounts receivable, there may come a time when it becomes clear that one or more accounts are simply not going to be paid. In these cases, the best course of action is often to write off the account.

Writing off an account means removing it from the accounts receivable balance, as it is no longer considered an asset of the company. The allowance for doubtful accounts journal entry for this is to:

• Debit allowance for doubtful accounts
• Credit accounts receivable

Remember that writing off an account does not necessarily mean giving up on receiving payment. In some cases, the company may still pursue collection through a collection agency, legal action, or other means.

4. Recover an account

Recovering an account means collecting a debt that has been previously written off or deemed uncollectible. If you recover money, you’ll want to make a journal entry adjusting your books to account for the recovery. The journal entry is:

• Debit accounts receivable or cash account
• Credit bad debt expense

Recovering an account may involve working with the debtor directly, working with a collection agency, or pursuing legal action.

Allowance for doubtful accounts benchmarks

Ideally, you’d want 100% of your invoices paid, but unfortunately, it doesn’t always work out that way. 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. 

Let’s examine some key benchmarks for the allowance for doubtful accounts. This table highlights standards for accounts receivable and days sales outstanding (DSO) for key industries, as collected by Dun & Bradstreet:

By analyzing such benchmarks, businesses can make informed decisions about their approach to managing their accounts receivable and avoiding potential financial losses.

Streamline your accounting and save time 

By estimating the expected uncollectible debts and creating an allowance for them, you can minimize the risk of significant losses arising from bad debts and ensure accurate financial statements. 

With accounting software like QuickBooks, you can access important insights, including your allowance for doubtful accounts. With such data, you can plan for your business’s future, keep track of paid and unpaid customer invoices, and even automate friendly payment reminders when needed.