How to Calculate Allowance for Doubtful Accounts and Record Journal Entries

23 April, 2024
10 mins
Rachelle Fisher, AVP, Digital Transformation

Table of Content

Key Takeaways
Introduction
What Is Allowance for Doubtful Accounts?
Why Is It Crucial to Create an Allowance for Uncollectible Accounts?
Example of Allowance for Doubtful Accounts
How to Calculate Allowance for Doubtful Accounts?
Allowance for Doubtful Accounts Journal Entry
How Can Automation and AI Help Reduce the Number of Doubtful Accounts?
How Can HighRadius Help?
FAQs 

Key Takeaways

  • The allowance for doubtful accounts (ADA) acts as a financial safety net, preparing your business for potential bad debts and ensuring smooth operations.
  • Choosing the right ADA calculation method, whether it’s the percentage of sales or AR aging, is crucial for accurate financial planning and risk mitigation.
  • Automation and AI can streamline collections, email correspondence, deductions, and payments, helping reduce the number of doubtful accounts.
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Introduction

Offering trade credit can be a tricky maneuver for businesses as it can lead to non-payment, late payments, or delinquent accounts. 

While in this competitive business landscape, you can not avoid offering trade credit; you can prevent it from hurting your business’s financial stability by creating an ‘Allowance for Doubtful Accounts”. 

No matter how careful you are while evaluating your customer creditworthiness, offering trade credits increases your risk of bad debts, as some buyers will inevitably be unable to pay.

In this article, we’ll explain what allowance for doubtful accounts is, why it matters, how to calculate it, and record journal entries for it.

What Is Allowance for Doubtful Accounts?

An allowance for doubtful accounts (uncollectible accounts) represents a company’s proactive prediction of the percentage of outstanding accounts receivable that they anticipate might not be recoverable. In simpler terms, it’s the money they think they won’t be able to collect from some customers.

But why bother predicting this? Well, rather than waiting for customers to default and hit you with unexpected financial hiccups, you can prepare in advance. You can create a cushion known as a ‘bad debt reserve.‘ This financial safety net ensures that even if some customers don’t pay up, it won’t disrupt your business operations.

The allowance for doubtful accounts resides within your balance sheet’s “contra assets” division. However, contrary to subtracting it, you actually incorporate it into your overall accounts receivable (AR). Why? Because it gives you a more realistic picture of the money, you can expect to collect from your customers.

Why Is It Crucial to Create an Allowance for Uncollectible Accounts?

There are many reasons why creating a provision for doubtful accounts may be prudent, like ensuring accurate financial reporting, managing your risk, and staying compliant.

  1. It plays a pivotal role in fine-tuning financial reports, making them more precise and reflective of reality. Without the allowance, the accounts receivable balance would overstate the assets because it would include amounts the company does not expect to collect.
  2. It allows the company to proactively manage credit risk by identifying and quantifying the portion of accounts receivable that may not be collectible. 
  3. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) require companies to estimate and record an allowance for doubtful accounts to comply with the principle of conservatism and to provide transparent financial information.

Example of Allowance for Doubtful Accounts

Now, let’s dive deeper into how allowance for uncollectible accounts works with a practical example.

Say you’ve got a total of $1 million in AR, but you estimate that 5% of it, which is $50,000, might not come in. Your net AR, the money you can count on, drops to $950,000.

In order to account for your possible bad debts, you will create an allowance for doubtful accounts worth $50,000. Here is how allowance for doubtful accounts on balance sheet will look like:

Balance Sheet Presentation:

Assets

Amount ($)

Accounts Receivable

$1,000,000

Less: Allowance for Doubtful Accounts

($50,000)

Net Accounts Receivable

$950,000

Now that you have got a grasp of what an allowance for doubtful accounts is and why it’s vital for your financial strategy, let’s understand how to calculate it. 

How to Calculate Allowance for Doubtful Accounts?

There are various methods to determine allowance for doubtful accounts, each offering unique insights into the potential risks your accounts receivable might carry. Here’s a breakdown of the two primary methods and some additional strategies used by businesses for ADA formula and calculation.

1. Percentage of sales method

This method focuses solely on your credit sales. By analyzing historical data, you can determine a suitable percentage of AR that may go unpaid. This could range from 2% for some companies to 5% for others, based on past performance.

Formula: Allowance for doubtful accounts = (Average expected bad debt * Total accounts receivable)

2. AR aging method

Unlike the percentage of sales method, this approach factors in both payment due dates and the duration for which they’ve been pending. Days Sales Outstanding (DSO) is used with windows, like 0-30 days, 30-60 days, and 60-90 days, are considered.

Formula: Allowance for doubtful accounts = (Expected bad debt for aging bucket 1 * Total accounts receivable for aging bucket 1 ) + (Expected bad debt for aging bucket 2 * Total accounts receivable for aging bucket 2 ) + …

3. Other methods

  • Risk classification method: Categorizes AR into risk categories (low, medium, high) and calculates ADA accounting based on average pending AR in these categories.
  • Historical percentage method: Utilizes past data on bad debts to estimate the ADA needed.
  • Pareto analysis: Focuses on analyzing the largest accounts, which typically contribute to 80% of receivables, to identify high-risk accounts. For smaller accounts, the historical percentage method is employed.

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Allowance for Doubtful Accounts Journal Entry

An allowance for doubtful accounts journal entry is a financial transaction that you record in the accounting books to adjust or create an allowance reserve that accounts for potential looses from uncollectible accounts receivable.

To account for potential bad debts, you have to debit the bad debt expense and credit the allowance for doubtful accounts. The allowance method journal entry takes the estimated amount of uncollectible accounts and establishes the allowance as a contra-asset, so it can either be zero or negative.

Here are a few scenarios that can arise when it comes to the entry of the allowance for doubtful accounts and their respective journal entries:

Scenario 1

A company estimates that it will have $15,000 in bad debt. They, therefore, record a journal entry by debiting the bad debt expense and crediting the allowance for doubtful accounts. 

This means if the net AR of the company is $200,000, the actual payment a business expects to receive is ($200,000 – $15,000 = $185,000). In this case, the allowance for bad debt journal entry would be as follows:

Account

Debit

Credit

Bad debt expense

$15,000

Allowance for doubtful accounts

$15,000

Scenario 2

Now, imagine that the company wants to write off $10,000 in bad debt out of the $15,000. To do so, the company debits the allowance for doubtful accounts and credits the AR. It’s important to note that the net AR remains unaffected, and only the remaining allowance for doubtful accounts is reduced from $15,000 to $5,000.

Account

Debit

Credit

Allowance for doubtful accounts

$10,000

Accounts receivable

$10,000

Scenario 3

In certain situations, there may be instances where a customer is initially unable to pay, resulting in a bad debt write-off. However, after a few weeks or months, the customer manages to make the payment and clear their dues. In such cases, the company follows a specific process. 

First, the company debits its AR and credits the allowance for doubtful Accounts. Then, a subsequent journal entry is made by debiting cash and crediting AR.

Account

Debit

Credit

Accounts receivable

$5,000

Allowance for doubtful accounts

$5,000

Cash

$5,000

Accounts receivable

$5,000

How Can Automation and AI Help Reduce the Number of Doubtful Accounts?

Today, agility and efficiency are paramount in business. Manual processes, while once the norm, can now be a bottleneck, leading to missed opportunities and increased risks. The good news is that the evolution of technology has given you powerful tools to transform your operations and supercharge your collections strategy – Automation and AI.

Here is how a reliable collections automation solution can help optimize your collections and reduce the need to create an allowance for doubtful accounts.

  • Predicting potential defaulters through advanced data analytics

    AI algorithms can analyze vast amounts of data, like customer payment history, credit scores, economic indicators, and industry trends, to identify patterns and predict which accounts are more likely to default. By leveraging predictive analytics, you can proactively manage credit risk and take preventive actions to reduce doubtful accounts.

  • Real-time credit health with AI-based credit scoring models

    AI-powered credit scoring models can assess the creditworthiness of customers in real-time based on a wide range of factors, such as payment history, income levels, and debt-to-income ratios. By automating the credit approval process and incorporating real-time data feeds, you can make more informed decisions about extending credit and reducing the likelihood of default.

  • Seamless dunning through automated collections

    AI-powered collection systems can automate the collections process by sending customers personalized reminders, notifications, and payment options based on their payment history and preferences. By automating routine collection tasks and optimizing communication channels, companies can save time, use resources more efficiently, and accelerate cash flow while reducing the number of overdue accounts.

Download our customer success story to find out how Staples reduced their bad debt by 20% with automation and AI.

How Can HighRadius Help?

HighRadius Collections Management Software, a component of the Order To Cash Product Suite, is powered by AI and offers a variety of features designed by experts to optimize your collections processes. Our extensive features include AI Prioritized Worklists, In-App Dialers, Intelligent Email Inboxes, Advanced Dunning, Generative AI via FreedaGPT, AP Portal Automation, In-App Payments Acceptance, Dispute Management, Proof of Delivery Automation, ERP Connectivity, Collection Agency Cases Integration, Customer Master Hierarchy Extensibility, and Activity Logging and Tracking. These modules streamline collections workflows, automate communication with customers, facilitate dispute resolution, integrate with ERP systems, and provide insights through data analytics, ultimately enhancing efficiency and effectiveness in your collections management.

With the use of our software, we have seen a 30%+ improvement in Collector Efficiencyand a 20+% Reduction in Past Due

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FAQs 

1. What is the purpose of doubtful accounts?

The purpose of doubtful accounts is to prepare your business for potential bad debts by setting aside funds. It ensures your company’s financial stability, preventing disruptions in case customers don’t pay. It is a preventive measure and helps you represent your financial records accurately.

2. Is allowance for doubtful accounts the same as bad debt expense?

No, allowance for doubtful accounts and bad debt expense are not the same thing. The allowance is an estimated reserve for potential bad debts created as a preventive measure, while bad debt expense is the actual amount recognized as a loss when a specific account is deemed uncollectible.

3. When should you write-off bad debt?

You should write off bad debt when it’s clear that a customer will not pay. This typically occurs after you have executed exhaustive collection efforts and negotiations. Writing bad debt off removes the debt from your accounts receivable, therefore, reflecting the loss accurately on your balance sheet.

4. What type of account is an allowance for doubtful accounts?

An allowance for doubtful accounts is a contra-asset account which means that it is listed as an asset but has a credit balance rather than a debit balance. It is deducted from the total accounts receivable on the balance sheet to show a more realistic picture of expected collectible amounts.

5. Is allowance for bad debts an asset?

Yes, allowance for bad debts is considered an asset on the balance sheet. However, it has a credit rather than a debit balance, also known as a contra asset. It reduces the accounts receivable balance to its estimated realizable value to account for potential bad debts.

6. What happens if bad debt exceeds allowance?

If the bad debt exceeds the allowance for doubtful accounts, it indicates that the company underestimated the risk of uncollectible accounts. You will need to adjust the accounts receivable balance on the balance sheet downwards to reflect the higher amount of uncollectible accounts.

7. What is an allowance for bad debt?

Allowance for bad debts is a financial reserve that a company sets aside to cover potential losses from customers who may not pay their debts. It safeguards against unexpected revenue shortfalls, protects the company’s financial stability, and accurately represents financial records. 

8. Is the allowance for doubtful accounts a debit or credit?

Allowance for doubtful accounts asset is a credit. It reduces accounts receivable on the balance sheet to reflect the amount expected to be uncollectible. This adjustment helps maintain accurate financial records by accounting for potential bad debts and helps businesses prepare for future bad debts.

9. What Is the average industry-wise allowance for doubtful accounts?

Industry-wise allowance for doubtful accounts can vary depending on factors like the nature of the industry, the types of customers served, economic conditions, and historical payment trends. Industries with higher credit risk or volatility maintain a higher ADA accounting compared to those with lower risk.

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