Businesses that offer trade credit to their customers keep an allowance for doubtful accounts on their balance sheet. It is an estimate of the amount of accounts receivable (AR) that a business expects to become bad debt.
Allowance for doubtful accounts falls under the contra assets section of a company’s balance sheet. It is then added to their total AR to get the approximate dues they expect will be cleared by their customers.
An allowance for doubtful accounts or uncollectible accounts is a prediction made by a company on the percentage of accounts receivable they foresee to be uncollectible.
So, instead of waiting for customers to default, businesses prepare in advance a bad debt reserve to ensure their operations aren’t affected by a sudden cash crunch.
Allowance for doubtful accounts is used in the accrual accounting method and also helps improve financial reporting accuracy. It also gives a detailed overview of a company’s revenue and expenses during a particular period.
Source – PYMNTS.com
It is critical to have an allowance for doubtful accounts as it indicates the bad debt expense a company expects to incur. It also helps to increase the accuracy of financial reports.
In 2021, Microsoft corporation published its annual financial report. Below is a snippet from the same which shows an ideal way to report the allowance for the doubtful accounts.
Source – Microsoft corporation annual report, 2021
There are two primary ways to calculate the allowance for doubtful accounts. They are:
It only takes into account the credit sales of a company. Here the business assesses its past records and chooses an appropriate percentage of AR they expect to go unpaid.
It could be 2% for some companies and 5% for others. Since the estimate is made by taking historical data into account, it gives a very close idea of the bad debt a business might incur.
For example, Company A identifies that its bad debt has been around 4-6% (of AR) for the past 3 years. It might then estimate that an average of 5% of its AR will go unpaid. Hence, if its total accounts receivable is $500,000, the allowance for doubtful accounts will be (5/100* 500000 = $25,000).
Average expected bad debt * Total accounts receivable = Allowance for doubtful accounts
Accounts receivable aging is a more precise method to calculate the allowance for doubtful accounts. Here a business takes into account both payment dues and the time it has been due for. There can be several windows like 0-30 days, 30-60 days, 60-90 days, and so on.
For example, company XYZ expects 2% of its payment dues between 0-30 days to turn into bad debt. While, the expected bad debt percentage for invoices that are due for 30-60 days and 60-90 days is 5% and 10% respectively.
So, if the accounts receivable during these periods are $100,000, $150,000, and $50,000, respectively, then: Allowance for Doubtful Accounts = (2/100 * 100,000) + (5/100 * 150,000) + (10/100 * 50,000) = $14,500
(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 ) + (Expected bad debt for aging bucket 3 * Total accounts receivable for aging bucket 3 )… = Allowance for doubtful accounts
There are several other methods like Risk classification, Historical percentage, and Pareto analysis used to calculate the allowance for doubtful accounts.
In the risk classification method, the average of the total pending AR in the different risk categories (low, medium, and high) is taken as the allowance for doubtful accounts.
The historical percentage method uses past data on bad debts to give an approximation of the allowance a business needs to keep for its doubtful accounts.
The Pareto analysis method analyzes only large accounts that total up to 80% of the overall receivables. Businesses can then identify the most important and high-risk accounts and get an approximate idea of which customers might default.
For the smaller accounts, the business then uses the historical percentage method. The Pareto analysis method is generally used by companies that have only a few large accounts.
The allowance for doubtful accounts varies widely from industry to industry. Since it is an estimate of the bad debt expense a company expects to incur, days sales outstanding (DSO) also plays a vital role in its calculation. In other words, the higher the DSO of a company, the higher its allowance must be.
For example, a report from D&B states that 78% of customers in the Mfg sheet metalwork industry pay on time, while this figure is only 42% for the equipment rental/leasing industry.
|Industry||Paying current||Up to 30 days late||30-60 days late||60-90 days late||91+ days late|
|Mfg sheet metalwork||77.6%||7.3%||1.5%||0.9%||12.7%|
So, the allowance will be lower for the metalwork industry and higher for the equipment rental industry.
Allowance for doubtful accounts fall under the contra assets section in the balance sheet, meaning it can either be zero or negative.
Below are a few scenarios to enter allowance for doubtful accounts in the balance sheet:
So, when a company estimates it will have $15,000 in bad debt, they debit bad debt expense on the balance sheet and credit the allowance for doubtful accounts.
|Bad debt expense||$15,000|
|Allowance for doubtful accounts||$15,000|
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).
Now, let’s say you want to write off $10,000 in bad debt for your business. In that case, the allowance for doubtful accounts will be debited, and accounts receivable will be credited. However, the net AR doesn’t get affected, and only the remaining allowance reduces from $15,000 to $5,000.
|Allowance for doubtful accounts||$10,000|
In some scenarios, there is a chance that a customer is unable to pay, and their AR is written off as bad debt. But a few weeks or months later, they make the payment and clear their dues. In such cases, the business must first debit its AR account and credit its allowance for doubtful accounts. After this, cash will be debited, and AR will be credited.
|Allowance for doubtful accounts||$5,000|
|Allowance for doubtful accounts||Bad debt expense|
|Allowance for doubtful accounts or allowance for uncollectible accounts is an estimation of the AR that a business expects to go unpaid. It is deducted from the total AR of a company even before a customer defaults. So, it is not necessarily the exact bad debt a company will incur. Sometimes the collections team might do an excellent job, and bad debt will be much lower, while at other times, it could be a lot higher.||Most B2B businesses operate by extending trade credit to their customers for a fixed time period. Customers who don’t pay on time are categorized as doubtful accounts. Among these doubtful accounts, some make the payment after multiple follow-ups, and some do not pay at all. So, bad debt expense is the AR that a business fails to recover from such accounts.|
Being proactive with your e-invoicing and collections process is the easiest way to reduce the number of doubtful or delinquent accounts. A reliable AR automation solution can help you achieve better cash flow, lower bad debt, and improve profits by analyzing customer behavior, risk, and past data.
Source – PYMNTS.com
HighRadius offers RadiusOne AR Suite for mid-market businesses and autonomous AR solutions for large enterprises. It can help your business reduce bad debt by prioritizing collections from high-risk customers, automating dunning processes, and providing real-time data and analytics. It also cuts down the invoicing costs, and reduces payment friction and DSO to eventually lower your allowance for doubtful accounts and bad debt expense.
An allowance for bad debt is a valuation account used to estimate the amount of a firm's receivables that may ultimately be uncollectible. Lenders use an allowance for bad debt because the face value of a firm's total accounts receivable is not the actual balance that is ultimately collected.
Allowance for doubtful accounts falls under contra assets and not the current assets section. A contra-asset account means its balance will either be zero or negative (credit balance).
Allowance for doubtful accounts is not a temporary account as they get carried forward to the next financial year. So, it is categorized under permanent accounts.
When the balance on allowance for doubtful accounts is credited, the bad debt expenses are debited.
Allowance for doubtful accounts is a credit account, meaning it can be either zero or negative. It records a decrease in the value of assets or an increase in liabilities.
Allowance for doubtful accounts falls under the contra-asset section, which means it will either be zero or negative. It is usually added to the total accounts receivable to give the net AR value.
Create working capital impact for companies of all sizesTalk to an expert
HighRadius Collections Software automates and optimizes the credit & collections management process to improve collector efficiency, minimize bad debt write-offs, improve customer relationships, and reduce DSO. It provides a complete set of tools to optimize and automate the credit collections management process and enable the better prioritization of credit collections activities All the information you need (invoices, dispute information, POD, claims, tracking info, etc.) on each case is automatically presented in a collections work-space and is ready for use. Apart from the wide variety of benefits that it has, it also comes with some amazing features like CADE (Collection Agency Data Exchange), collector’s dashboard which has prioritized collections worklist, automated dunning & correspondence, dispute management, centralized tracking of notes, call logs & payment commitments along with cash forecasting functionalities. The result is a more efficient collections team that contributes to enhanced cash flow and reduced DSO.