How to Create a Bad Debt Allowance for Doubtful Accounts

Posted by Ryan Howard on Jun 29, 2021 12:35:42 PM

How to Create a Bad Debt Allowance for Doubtful Accounts

Every time your business submits an invoice, there is the risk that the invoice will not be paid.  By accounting for this in financial statements, you're able to get an accurate picture of the actual value of receivables.  When you're certain that an account is not collectible, for instance, you have the option to remove it from accounts receivable in your financial books by writing it off as bad debt.  If you're doubtful that the account will be paid but you're not quite ready to write it off, it's referred to as a doubtful account

Here's how to create a bad debt allowance for doubtful accounts.


Why Account for Doubtful Accounts?

Because of the risk of an unpaid invoice, generally accepted accounting principles state that the allowance for doubtful accounts must be estimated and recorded in the same reporting period as the sale.  By recording it within the same period as the sale, if the account becomes bad debt at a later period, it will have already been expected due to the contra account (or bad debt reserve) created previously.

How to Account for Doubtful Accounts

To make a journal entry for the allowance of doubtful accounts, there needs to be a credit and a debit. The Bad Debt Expense account will be debited to the doubtful accounts balance as an expense. The debit will go to the allowance for doubtful accounts. The doubtful accounts balance will offset accounts receivable. When the account becomes bad debt, the allowance for doubtful accounts will be credited. 

By accounting for this risk, the financial reporting of accounts receivable reveals a clearer idea of its assets and what to expect in terms of future bad debts. This also allows the expenses to be properly matched to the bad debt. 

How to Estimate Doubtful Accounts Balance

Here are a few methods to use when estimating how much to consider for the doubtful accounts balance:

  • Percentage of Sales: Calculate a standard percentage of sales that will likely go unpaid during a particular time period. 

  • Risk classification: Assign a risk score to each customer account.  Multiply the risk score by those customer balances. 

  • Historical percentage: Review previous bad debts and use the percentage to predict future bad debts.

  • Pareto analysis:  For a limited amount of large invoices, the risk classification is used for the larger accounts (80%) and the historical percentage is used for smaller accounts (20%). 

  • Accounts receivable aging:  Review aging reports from previous years to determine the predictability of accounts going unpaid.  As an example:

    • Uncollected receivables are typically:

      • 5% of accounts receivable are >30 days late

      • 1% of accounts receivable <30 days late

    • Receivables are:

      • $2,000  > 30 days late

      • $10,000 < 30 days late

    • Allowance for doubtful accounts estimate is:

      • $2,000 X 5% = $100

      • $10,000 X 1% = $100

      • Allowance for doubtful accounts balance is: $100 + $100 = $200 

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Collect Bad Debt and Doubtful Accounts

You do have options to collect doubtful accounts and bad debt. If doubtful accounts or untrustworthy clients are being written off or low amount invoices are being pushed to the back burner, Enterprise Recovery can help.  Our services include:

Learn more about our company here and contact us for questions regarding your client collections!

Topics: Best Practices, Accounts Receivable