Net Accounts Receivable: Allowance for Doubtful Accounts - Online Tutor, Practice Problems & Exam Prep

In accounting, the allowance for doubtful accounts (ADA) is a contra asset account that estimates uncollectible accounts receivable, aligning with the matching principle of GAAP. Bad debt expense (BDE) is recorded when credit sales occur, reflecting anticipated losses. Two methods for estimating ADA include the percentage of sales method, which calculates BDE as a percentage of credit sales, and the aging of receivables method, which assesses the collectibility based on the age of receivables. This ensures accurate financial reporting and adherence to accounting standards.

Net Accounts Receivable: Allowance for Doubtful Accounts

So when we're dealing with accounts receivable and bad debt expense, GAAP requires us to use an allowance account. Let's check that out. Like I said, GAAP requires the use of an allowance. This helps us conform with the matching principle. When we talked about the direct write-off method, it was not GAAP because it didn't follow the matching principle, okay? Bad debt expense, we talked about a little, but these are the losses that occur from extending credit to a customer but not getting paid, right? So we sold them something and said, okay, you can pay us later and then they never paid us later, well we have bad debt expense. Okay? And usually, when I write this, I'm going to shorthand it to BDE for bad debt expense. It's just a long thing to write and you can get away with BDE. Alright.

Just like allowance doubtful accounts, this is our big topic here and we're going to be short handing it as ADA for allowance for doubtful accounts. Well and by the way sometimes it's called allowance for uncollectible accounts something like that but this is the most common format, allowance doubtful accounts. So this account, it's a contra asset. Okay? We've talked about contra assets once before, but just so you remember, a contra asset, they're going to be paired with another account. And in this case, they're paired with accounts receivable. Okay? What a contra asset has is an opposite balance of the actual asset. So if you think about an asset, accounts receivable, it's going to have a debit balance. Right? That's how we're used to accounts receivable. Well, the allowance for doubtful accounts is going to have a credit balance, right? So the debit balance in accounts receivable and the credit balance in the allowance, well, that credit balance is going to lower the net balance, right? It's going to bring the debit a little lower because there are some credits over here. Alright?

We'll see more details about that, but remember a contra asset, they have an opposite balance than the regular account. So, if I was just hypothetically speaking, say, a contra liability, right? A contra liability, well, a liability has a credit balance, so a contra liability would have a debit balance. Okay?

So, the allowance, what we use it for is to estimate. The allowance helps us estimate the amount of bad debt in our accounts receivable, right? So if you think about it, we've got a certain amount of accounts receivable right now. Well, there's going to be in that batch of accounts receivable some amount of it that's bad debt, right? Well, the allowance helps us estimate that amount. So let's see how this happens and how we follow the matching principle here. Alright?

In year 1, we have credit sales, right? So in year 1, notice we have credit sales, so we take an entry like debiting accounts receivable and crediting revenue. Right? Because this is a credit sale. We're going to be paid sometime in the future. But we're also going to have another entry at this point to deal with the bad debt expense. Okay? So we're going to estimate from all these accounts receivable. We made all these credit sales and we have all these accounts receivable. We're going to estimate how much of it is not collectible. Okay? So that's what we're going to make this second entry. Notice in year 1, we're making an entry for bad debt expense. So bad debt expense is going to be debited and we're going to credit the allowance for doubtful accounts. So notice we credited allowance for doubtful accounts, right? So that was a contra asset, right? This is a credit balance that's related to our accounts receivable account, Okay? So notice what happened. In year 1, we took our revenue and we took a related expense. Okay? So that's the matching principle. It all happened in year 1.

Now notice what happens in year 2. In year 2, we finally decide, hey, we're not going to be able to collect some certain amount of that money. Well, that's fine. We already took the expense. We're not going to take an expense at this point. So notice that the expense, the bad debt expense, it got put into the allowance for doubtful accounts, right? So whenever we want to write off an account in the allowance method, we're going to debit the allowance because it's coming out of the allowance. So this will lower the balance in the allowance and we're going to credit accounts receivable, right, to get the account receivable off of our books. Think about it. We had this account receivable on our books and now we're finally deciding that we're not going to collect it. Well, we have to credit it to get rid of it and we already took the bad debt expense related to that account in year 1. So now in year 2, we just have to decrease the allowance because this is us finally finding that bad debt that we expected in year 1. Okay?

So we would decrease the allowance and our accounts receivable in those amounts that we decided were uncollectible and those numbers would all have to be given to you. They would have to tell you, oh, $1,000 was deemed uncollectible in year 2 or, you know, all these things have there's going to be a lot that has to be given to you in these questions. So when we calculate our allowance, we're going to deal with 2 methods that we're going to talk about in a separate video. The first one is the percentage of sales method and with this method, the bad debt expense is estimated as, guess what, a percentage of credit sales. So we're going to have so many credit sales in this year, say we had $1,000,000 worth of credit sales and we'll say 3% of those are uncollectible, right? So we'll be able to find out how much is uncollectible, well, 3% of that million. Okay?

So notice in this method, what we calculate is the bad debt expense and then we can find the ending balance in the allowance using that information. Now, don't worry too much about the details. There's going to be much more detailed explanations of this. I'm just showing you the 2 methods here. The second one, aging of receivables method. Well, in this method, we're going to see how old every receivable is, right? We would expect a receivable that's only been in our account for 2 weeks. Well, we could probably still collect that, but maybe a receivable that's been in the account for 2 years, well, you know maybe that money's not coming in. So what we do is we use a schedule based on the age and then we estimate what the ending balance in the allowance should be and this is based on the age of each receivable. Right? So the older the receivable, the more likely that we won't collect it. So in this method, notice we calculate the ending balance.

So the percentage of sales method, we calculate the bad debt expense, the aging of receivables, we calculate the ending balance in the allowance, okay? And then we back into our bad debt expense. Cool. Let's pause real quick. This has been quite a hefty topic and then we'll do this example below, alright? Let's do that.

Allowance for Doubtful Accounts

A company regularly sells items on account, currently accounts receivable total $12,000. However, the company estimates that $800 of this amount is uncollectible. They provided this number directly; we are not using common accounting methods like the aging method here. So, we need to record a bad debt expense (BDE) of $800, as that is the amount estimated to be uncollectible. We then credit our allowance for doubtful accounts, a contra asset that reduces the value of our receivables.

The bad debt expense reduces our equity as it is an expense on the income statement for $800, and the allowance for doubtful accounts reduces our net accounts receivable by the same amount since we do not expect to collect $800 of our accounts receivable. This is how the net accounts receivable is computed: we take the gross receivables which is the total amount recorded in the accounts receivable account and subtract the allowance for doubtful accounts. The accounts receivable account with a debit balance, and the ADA, having a credit balance, reduces the total value of the receivables leading to the net accounts receivable figure usually reported under assets.

Let's explore the T accounts process further. Every balance sheet account generally follows the basic formula of beginning balance plus additions to the account minus subtractions from the account equals the ending balance. For accounts receivable (AR), it involves managing a series of debit entries from credit sales, which increase the AR balance, and credits from cash collections and write-offs which decrease it. This system allows us to arrive at the ending balance of accounts receivable.

Regarding the allowance for doubtful accounts (ADA), it generally starts with a credit balance. Increases in this account occur with bad debt expenses – these are recorded as debits to bad debt expense and credits to the allowance. Conversely, the allowance is decreased through account write-offs. This leads to an ending balance in the ADA, which should be a credit balance. Combined, the net accounts receivable is the gross accounts receivable minus the allowance for doubtful accounts.

This method provides a clear picture of the dynamics of accounts receivable management and its impact on a company's financial statements. Let's proceed to understand more details in the next video.

Here’s what students ask on this topic:

What is the allowance for doubtful accounts and why is it important?

The allowance for doubtful accounts (ADA) is a contra asset account used to estimate the portion of accounts receivable that may not be collected. It is important because it aligns with the matching principle of GAAP, ensuring that expenses are recorded in the same period as the related revenues. This estimation helps provide a more accurate picture of a company's financial health by reflecting potential losses from credit sales, thereby improving the reliability of financial statements.

How does the percentage of sales method work for estimating bad debt expense?

The percentage of sales method estimates bad debt expense as a percentage of total credit sales for a period. For example, if a company has $1,000,000 in credit sales and estimates that 3% will be uncollectible, the bad debt expense would be $30,000. This method focuses on calculating the bad debt expense directly, which is then used to adjust the allowance for doubtful accounts.

What is the aging of receivables method and how is it used?

The aging of receivables method involves categorizing accounts receivable based on their age and estimating the likelihood of collection for each category. Older receivables are considered less likely to be collected. A schedule is created to determine the ending balance in the allowance for doubtful accounts. This method calculates the ending balance in ADA first, and then the bad debt expense is derived from this balance.

Why is the direct write-off method not GAAP compliant?

The direct write-off method is not GAAP compliant because it does not adhere to the matching principle. This method records bad debt expense only when specific accounts are deemed uncollectible, which may occur in a different period from when the related revenue was recognized. This mismatch can distort financial statements, making them less reliable and less reflective of the company's true financial position.

How do you record a write-off using the allowance method?

To record a write-off using the allowance method, you debit the allowance for doubtful accounts and credit accounts receivable. This entry removes the uncollectible amount from accounts receivable and reduces the allowance account. Since the bad debt expense was already recorded when the allowance was initially estimated, no additional expense is recognized at the time of the write-off.