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Balance Sheet Core Concepts
Shareholders' Equity Section Allowance for Doubtful Accounts: Balance Sheet AccountingThe allowance for doubtful accounts (or the “bad debt” reserve) appears on the balance sheet to anticipate credit sales where the customer cannot fulfill their payment obligations. Credit sales all come with some degree of risk that the customer might not hold up their end of the transaction (i.e. when cash payments left unmet). In accordance with GAAP revenue recognition policies, the company must still record credit sales (i.e. not cash) as revenue on the income statement and accounts receivable on the balance sheet. The allowance for doubtful accounts is then used to approximate the percentage of “uncollectible” accounts receivable (A/R). Allowance for Doubtful Accounts: Contra-Asset ClassificationThe allowance for doubtful accounts is management’s objective estimate of their company’s receivables that are unlikely to be paid by customers. On the balance sheet, an allowance for doubtful accounts is considered a “contra-asset” because an increase reduces the accounts receivable (A/R) account.
The allowance reserve is set in the period in which the revenue was “earned,” but the estimation occurs before the actual transactions and customers can be identified. The actual payment behavior of customers, or lack thereof, can differ from management estimates, but management’s predictions should improve over time as more data is collected. GAAP allows for this provision to mitigate the risk of volatility in share price movements caused by sudden changes on the balance sheet, which is the A/R balance in this context. Matching Principle: Bad Debt and RevenueThe projected bad debt expense is matched to the same period as the sale itself so that a more accurate portrayal of revenue and expenses is recorded on financial statements. In effect, the allowance for doubtful accounts leads to the A/R balance recorded on the balance sheet to reflect a value closer to reality. Otherwise, it could be misleading to investors who might falsely assume the entire A/R balance recorded will eventually be received in cash (i.e. bad debt expense acts as a “cushion” for losses). Allowance Method: Journal Entries (Debit and Credit)The allowance method estimates the “bad debt” expense near the end of a period and relies on adjusting entries to write off certain customer accounts determined as uncollectable.
The most prevalent approach — called the “percent of sales method” — uses a pre-determined percentage of total sales assumption to forecast the uncollectible credit sales. Management projects the amount of bad debt by referencing historical data such as the following:
The journal entries for recording the uncollectible A/R are as follows:
Note that the accounts receivable (A/R) account is NOT credited, but rather the allowance account for doubtful accounts, which indirectly reduces A/R. Most balance sheets report them separately by showing the gross A/R balance and then subtracting the allowance for doubtful accounts balance, resulting in the “Accounts Receivable, net” line item.
Microsoft Allowance for Doubtful Accounts Example“The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence” Allowance for Doubtful Accounts Schedule (Source: MSFT 10-K) Direct Write-Off MethodThe write-off method violates the matching principle under U.S. GAAP since the expense is recognized in a different period as when the revenue was earned. Moreover, using the direct write-off method is prohibited for reporting purposes if the company’s business model is characterized by a significant amount of credit sales (i.e. paid on credit) with large A/R balances. But if the company’s total revenue is primarily from cash sales rather than credit sales, and the receivables balance is minimal — the company could potentially opt to use the direct write-off method when calculating the expense pending approval. Allowance for Doubtful Accounts Journal Entry ExampleSuppose a company generated $1 million of credit sales in Year 1 but projects that 5% of those sales are very likely to be uncollectible based on historical experience.
Given the $50,000 of projected bad debts, the accounting journal entries at the end of Year 1 are as follows:
The bad debt expense is entered as a debit to increase the expense, whereas the allowance for doubtful accounts is a credit to increase the contra-asset balance. As companies report their financial statements near the end of the fiscal period, adjusting entries are necessary to arrive at the “Accounts Receivable, net” balance and recognize a “Bad Debt” expense in the corresponding period.
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The allowance for doubtful accounts is a reduction of the total amount of accounts receivable appearing on a company’s balance sheet, and is listed as a deduction immediately below the accounts receivable line item. This deduction is classified as a contra asset account. The allowance represents management’s best estimate of the amount of accounts receivable that will not be paid by customers. It does not necessarily reflect subsequent actual experience, which could differ markedly from expectations. If actual experience differs, then management adjusts its estimation methodology to bring the reserve more into alignment with actual results. How to Estimate the Allowance for Doubtful AccountsThere are several possible ways to estimate the allowance for doubtful accounts, which are noted below. Estimation by Risk ClassificationAssign a risk score to each customer, and assume a higher risk of default for those having a higher risk score. Estimation by Historical PercentageIf a certain percentage of accounts receivable became bad debts in the past, then use the same percentage in the future. This method works best for large numbers of small account balances.
Review the largest accounts receivable that make up 80% of the total receivable balance, and estimate which specific customers are most likely to default. Then use the preceding historical percentage method for the remaining smaller accounts. This method works best if there are a small number of large account balances. You can also evaluate the reasonableness of an allowance for doubtful accounts by comparing it to the total amount of seriously overdue accounts receivable, which are presumably not going to be collected. If the allowance is less than the amount of these overdue receivables, the allowance is probably insufficient. You should review the balance in the allowance for doubtful accounts as part of the month-end closing process, to ensure that the balance is reasonable in comparison to the latest bad debt forecast. For companies having minimal bad debt activity, a quarterly update may be sufficient. Fraudulent Use of the Allowance for Doubtful AccountsCompanies have been known to fraudulently alter their financial results by manipulating the size of this allowance. Auditors look for this issue by comparing the size of the allowance to gross sales over a period of time, to see if there are any major changes in the proportion. Accounting for the Allowance for Doubtful AccountsIf a company is using the accrual basis of accounting, it should record an allowance for doubtful accounts, since it provides an estimate of future bad debts that improves the accuracy of the company’s financial statements. Also, by recording the allowance at the same time it records a sale, a company is properly matching the projected bad debt expense against the related sale in the same period, which provides an accurate view of the true profitability of a sale. For example, a company records $10,000,000 of sales to several hundred customers, and projects (based on historical experience) that it will incur 1% of this amount as bad debts, though it does not know exactly which customers will default. It records the 1% of projected bad debts as a $100,000 debit to the Bad Debt Expense account and a $100,000 credit to the Allowance for Doubtful Accounts. The bad debt expense is charged to expense right away, and the allowance for doubtful accounts becomes a reserve account that offsets the account receivable of $10,000,000 (for a net receivable outstanding of $9,900,000). The entry is:
Other IssuesThe 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. Similar TermsThe allowance for doubtful accounts is also known as the allowance for bad debt and bad debt allowance. August 13, 2022/ |