When it comes to your small business, you don’t want to be in the dark. Your accounting books should reflect how much money you have at your business. If you use double-entry accounting, you also record the amount of money customers owe you. What happens if they don’t pay? Create an allowance for doubtful accounts (ADA) to protect your business.
If you extend credit to customers, you need to know about an allowance for doubtful accounts. This type of journal entry can maintain the overall accuracy of your books and prevent unexpected losses.
What is allowance for doubtful accounts?
An allowance for doubtful accounts, or bad debt reserve, is a contra asset account (it either has a credit balance or a balance of zero) that decreases your accounts receivable. By creating an allowance for doubtful accounts entry, you are estimating that some customers won’t pay you the money they owe.
When customers don’t pay you, your bad debts expenses account increases. A bad debt is debt that you have officially written off as uncollectible. It is money you thought you would receive but don’t, so it impacts your company’s bottom line.
Unlike bad debt, doubtful debt isn’t officially uncollectible. Instead, doubtful debt is money you predict will turn into bad debt, but there’s still a chance that you will receive the money.
Use an allowance for doubtful accounts entry when you extend credit to customers. Extending credit to customers lets them make purchases without paying immediately. Despite not physically having the cash, you need to record the transaction.
If you extend credit to customers, you use the accrual accounting method. When customers purchase from you but don’t pay right away, you must increase your accounts receivable account. This is the money owed to your business. But sometimes, customers never pay you.
Unpaid payments become bad debts. Suddenly having a lot of bad debts drives down the amount of revenue your business should have. ADA accounting helps increase the accuracy of your books. By predicting the amount of accounts receivables customers won’t pay, you can anticipate your losses associated with bad debts.
Allowance for doubtful accounts on the balance sheet
When you create an allowance for doubtful accounts, you must record the amount on your business balance sheet. The balance sheet is a financial statement that looks at your company’s assets, liabilities, and equity.
Because an allowance for doubtful accounts is a contra asset that reduces your accounts receivables, it is recorded under assets, immediately as a reduction after the accounts receivables line. For example:
- Cash: 500
- Accounts receivable: 1,000
- Less allowance for doubtful accounts: (300)
If the doubtful debt turns into a bad debt, you must record it as an expense on your small business income statement.
Allowance for doubtful accounts calculation
For many business owners, it can be difficult to estimate your allowance for doubtful accounts. There are a few different ways you can calculate your predictions.
You can make your predictions based on past data. Use the percentage of bad debts you had in the previous accounting period and apply it to your estimate. For example, if 2% of your sales were uncollectible, you could set aside 2% of your sales in your ADA account. Let’s say you have a total of $50,000 in accounts receivable ($50,000 X 2%). Your allowance for doubtful accounts would be $1,000.
Aging of receivables
Another method you can use is the aging of accounts receivable method. Using the aging of receivables, you can group your outstanding accounts receivable by age and assign a percentage indicating how many will be collected.
For example, 10% of accounts receivable that are between 31 – 60 days outstanding are uncollectible. You are waiting on $2,000 worth of payments in this aging period. Multiply your accounts receivable by the percentage ($2,000 X 10% = $200).
And, 5% of accounts receivable under 30 days outstanding will be uncollectible. You are waiting on $10,000 in this aging period. Multiply the amount of accounts receivable for this period by its percentage ($10,000 X 5% = $500).
Now, add the two aging group values together ($200 + $500 = $700). Your allowance for doubtful accounts estimation would be $700.
Allowance for doubtful accounts journal entry
To predict your company’s bad debts, you must create an allowance for doubtful accounts entry. You must also use another entry, bad debts expense, to balance your books. Increase your bad debts expense by debiting the account, and decrease your ADA account by crediting it.
Let’s say your business brought in $100,000 worth of sales in an accounting period. Based on past trends, you predict that 3% of your sales will be bad debts. You must record $3,000 as a debit in your bad debts expense account and a matching $3,000 as a credit in your allowance for doubtful accounts.
|Bad Debts Expense||Estimated default payments||3,000|
|Allowance for Doubtful Accounts||3,000|
When a doubtful debt turns into a bad debt, you will need to credit your accounts receivable account. This decreases the amount of money owed to your business. You must also debit your allowance for doubtful accounts.
For example, your business is unable to collect $2,000 of the money owed to you. Your journal entry should look like this:
|Allowance for Doubtful Accounts||Default payments||1,000|
What happens if customers do pay?
If a customer ends up paying (e.g., a collection agency collects their payment) and you have already written off the money they owed, you will need to reverse the account. Debit your accounts receivable account and credit your allowance for doubtful accounts.
|Accounts Receivable||Default payments||1,000|
|Allowance for Doubtful Accounts||1,000|
Allowance for doubtful accounts at a glance
As a quick recap, here are some common questions and answers associated with an allowance for doubtful accounts.
What type of account is allowance for doubtful account?
An ADA account is a contra asset account, meaning it either has a credit balance or a balance of zero.
What does an allowance for doubtful accounts do?
An allowance for doubtful accounts assumes some customers won’t pay you and reduces your reported amount of accounts receivables.
When do I use an allowance for doubtful accounts?
Use an allowance for doubtful accounts when you extend credit to customers.
What’s the difference between doubtful debt and bad debt?
Doubtful debt is debt you predict you won’t be able to collect while bad debt is money you have officially written off as uncollectible.
How do I create an allowance for doubtful accounts entry?
In your double-entry books, debit your bad debts expense account and credit your ADA account. When there is a bad debt, debit your ADA account and credit your accounts receivable account.
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This article has been updated from its original publication date of 11/12/2014.
This is not intended as legal advice; for more information, please click here.