How does an allowance for doubtful accounts work? 2021

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What is the Allowance for Doubtful Accounts? The allowance reflects management’s best estimate of the amount of accounts receivable that customers will not pay. The allowance for doubtful accounts is commonly known as the bad debt allowance. Nội dung chính What is the Allowance for Doubtful Accounts? Key Learning Points Working Example More Detail How is allowance for doubtful accounts recorded? What is allowance for doubtful accounts example? What happens when you debit allowance for doubtful accounts? What is the allowance method for doubtful debt? Key Learning Points The allowance for doubtful accounts reduces the value of accounts receivable in the balance sheet, to reflect amounts that the company does not expect to receive from customers. Management does not know with certainty which customers will or won’t pay, so the allowance is estimated using historic information on customer default. Overview Allowance for doubtful accounts is a contra asset that reduces the total amount of accounts receivable. It is important to note that it does not necessarily reflect subsequent payment of receivables, which may differ from expectations. If actual bad debts differ from the estimated amount, management must adjust its estimate to align the reserve with actual results. The only impact that the allowance for doubtful accounts has on the income statement is the initial charge to bad debt expense when the allowance is initially funded. Any subsequent write-offs of accounts receivable against the allowance for doubtful accounts only impact the balance sheet. Working Example Below is an example that demonstrates how the allowance for doubtful accounts works. Blustrata Inc. records $50,000,000 in sales. Based on historical reporting, bad debts typically average 2% of receivables. Note that Blustrata Inc. does not know which customers will default. Blustrata Inc. then records the 2% of receivables as projected bad debts, making a $1,000,000 debit to the Bad Debt Expense account and a $1,000,000 credit to the Allowance for Doubtful Accounts. The bad debt expense is charged to expenses right away. The allowance for doubtful accounts becomes a reserve account that offsets the accounts receivable total of $50,000,000 (for a net receivable outstanding of $49,000,000). Here is the entry: Debit Credit Bad Debt Expense 1,000,000 Allowance for Doubtful Accounts 1,000,000 Several weeks later, a few customers defaulted on payments totaling $300,000. Blustrata Inc. then credits the accounts receivable account by 0,000, reducing the number of outstanding accounts receivable, and debits the Allowance for Doubtful Accounts by 0,000. This entry reduces the balance in the allowance account to $700,000. Please note that the entry has no impact on earnings in the current period. The entry is: Debit Credit Allowance for Doubtful Accounts 300,000 Accounts Receivable 300,000 Six months later, Redfin Debt Collectors succeeded in collecting $150,000 of previously written-off receivables. Blustrata Inc can now reverse part of the previous entry, increasing the balances of both accounts receivable and the allowance for doubtful accounts. The entry is: Debit Credit Accounts Receivable 150,000  Allowance for Doubtful Accounts 150,000 More Detail The allowance can be calculated using different methodologies, and a straightforward way is to use historical context. If a certain percentage of accounts receivable is typically written off, it’s reasonable to use that percentage as an estimate. Below are two methods for estimating the amount of accounts receivable that are not expected to be converted into cash. Percentage of Credit Sales – If a company and/or industry reported a long-run average of 4% of credit sales as uncollectible, the company would enter 4% of each period’s credit sales as a debit to bad debt expense and a credit to allowance for doubtful accounts. Accounts Receivable Aging – The accounts receivable aging method is a report that lists unpaid customer invoices by date ranges and applies a rate of default to each date range. The allowance for doubtful accounts is as follows: ($320,000 x 1%) + ($330,000 x 15%) + ($150,000 x 25%) + ($250,000 x 30%) = $165,200 Conclusion The allowance for doubtful accounts ensures that the financial statements are prudent, by reflecting management’s expectations – not just contractual amounts – in the balance sheet. It, therefore, helps analysts make better predictions of the cash flows the company expects to receive from customers. How is allowance for doubtful accounts recorded? Allowance for doubtful accounts on the balance sheet When you create an allowance for doubtful accounts, you must record the amount on your business balance sheet. If the doubtful debt turns into a bad debt, record it as an expense on your income statement. What is allowance for doubtful accounts example? 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 reporting $3,000 in bad debt expense. What happens when you debit allowance for doubtful accounts? When the credit balance of the Allowance for Doubtful Accounts is subtracted from the debit balance in Accounts Receivable the result is known as the net realizable value of the Accounts Receivable. The credit balance in this account comes from the entry wherein Bad Debts Expense is debited. What is the allowance method for doubtful debt? The allowance method involves setting aside a reserve for bad debts that are expected in the future. The reserve is based on a percentage of the sales generated in a reporting period, possibly adjusted for the risk associated with certain customers.

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