This allowance tries to predict the percentage of receivables that may not be collectible, but actual customer payment behavior can vary greatly from the estimate. Note that the asset account balance represents the purchase price of the asset in question, also known as its historical cost. It’s important to note that an allowance for doubtful accounts is simply an informed guess, and your customers’ payment behaviors may not align. Let’s explore the importance of allowance for doubtful accounts, the methods of estimating it, and how to record it. A Pareto analysis is a risk measurement approach that states that a majority of activity is often concentrated among a small amount of accounts. In many different aspects of business, a rough estimation is that 80% of account receivable balances are made up of a small concentration (i.e. 20%) of vendors.

Historical Percentage Method

No, allowance for doubtful accounts and bad debt expense are not the same thing. As mentioned, contra asset accounts are usually listed below their matching asset accounts, and the net values of those assets are written next to the contra accounts. Whenever the balance of a contra asset account increases (credit to the contra asset account), the increased amount is written off as an expense and is reported in the company’s income statement. When a business makes credit sales, there’s a chance that some of its customers won’t pay their bills—resulting in uncollectible debts.

Fundamentals of Bad Debt Expenses and Allowances for Doubtful Accounts

Last, for contra revenue accounts there are sales discounts, sales allowances, or sales returns. These contra revenue accounts tend to have a debit balance and are used to calculate net sales. To illustrate, let’s continue to use Billie’s Watercraft Warehouse (BWW) as the example. Below is an example that demonstrates how the allowance for doubtful accounts works.

Methods for Estimating Doubtful Accounts

Some companies may classify different types of debt or different types of vendors using risk classifications. For example, a start-up customer may be considered a high risk, while an established, long-tenured customer may be a low risk. In this example, the company often assigns a percentage to each classification of debt. Then, it aggregates all receivables in each grouping, calculates each group by the percentage, and records an allowance equal to the aggregate of all products.

Allowance for doubtful accounts on the balance sheet

The debit to bad debts expense would report credit losses of $50,000 on the company’s June income statement. The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance. The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet.

What Is the Benefit of Using a Contra Account?

• For example, an asset was purchased by a company for $100,000 – that is, the historical cost of the asset was $100,000 – and its contra asset counterpart has a balance of $30,000.
• This amount is referred to as the net realizable value of the accounts receivable – the amount that is likely to be turned into cash.
• He’s currently a VP at KCK Group, the private equity arm of a middle eastern family office.
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• 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.
• There are various methods to determine allowance for doubtful accounts, each offering unique insights into the potential risks your accounts receivable might carry.

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 the allowance for doubtful accounts is a contra asset account that equals: while simultaneously reporting $3,000 in bad debt expense. Whereas assets normally have positive debit balances, contra assets, though still reported along with other assets, have an opposite type of natural balance.

• 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.
• Though this allowance for doubtful accounts is presented on the balance sheet with other assets, it is a contra asset that reduces the balance of total assets.
• In certain situations, there may be instances where a customer is initially unable to pay, resulting in a bad debt write-off.
• The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.

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3 Bad Debt Expense and the Allowance for Doubtful Accounts