What is the Effect of Allowance for Doubtful Accounts on the Financial Statements?

The allowance for doubtful accounts is a balance sheet account that reduces the reported amount ofaccounts receivable. (A change to the balance in the allowance for doubtful accounts also affects bad debt expense on the income statement.)

You can not expect all to work as determined. Eg debtors, usage of assets. Providing allowance / room for likely failure in certain aspects is positive but to the incompetent the effect is to plan loopholes to steal / rob business funds hoping they Will be idle at close of acvounting period. Close eye should be paid at sll cost but by putting a hawk eyed Accountant, before the auditor. Bad effect

The Effect of Allowance for Doubtful Accounts on the financial statements is that it is first the contra asset account. It is shown on the Assets side of the Balance sheet below the accounts receivable line. It is the estimate of management to clear accounts receivable which are not in moving conditions means from whom money is not going to come in, its rather bad debts and providing (provision) for such accounts receivable is called allowance for doubtful accounts. Therefore its effect will be it would be shown as is listed as deduction immediately below the accounts receivable line item on the assets side of the balance sheet.

The Allowance for Doubtful Accounts

Overview of the Allowance for Doubtful Accounts

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 for doubtful accounts 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.

Estimation Techniques for the Allowance for Doubtful Accounts

There are several possible ways to estimate the allowance for doubtful accounts, which are:

• Risk classification. Assign a risk score to each customer, and assume a higher risk of default for those having a higher risk score. Click here to read the full article on risk-based bad debt forecasting.
• Historical percentage. If 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.
• Pareto analysis. 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 your latest bad debt forecast. For companies having minimal bad debt activity, a quarterly update may be sufficient.

Companies 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 Accounts

If 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 for doubtful accounts 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:

  Debit Credit Bad Debt Expense 100,000        Allowance for Doubtful Accounts   100,000

Later, several customers default on payments totaling $40,000. Accordingly, the company credits the accounts receivable account by $40,000 to reduce the amount of outstanding accounts receivable, and debits the Allowance for Doubtful Accounts by $40,000. This entry reduces the balance in the allowance account to $60,000. The entry does not impact earnings in the current period. The entry is:

  Debit Credit Allowance for Doubtful Accounts 40,000        Accounts Receivable   40,000

A few months later, a collection agency succeeds in collecting $15,000 of the funds that the company had already written off. The company can now reverse part of the previous entry, thereby increasing the balances of both accounts receivable and the allowance for doubtful accounts. The entry is:

  Debit Credit Accounts Receivable 15,000        Allowance for Doubtful Accounts   15,000

Other Issues

The 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 Terms

The allowance for doubtful accounts is also known as the allowance for bad debt and bad debt allowance.

The allowance for doubtful accounts is a balance sheet account that reduces the reported amount of accounts receivable. (A change to the balance in the allowance for doubtful accounts also affects bad debt expense on the income statement.) Providing an allowance for doubtful accounts presents a more realistic picture of how much of the accounts receivable will be turning to cash. After all, a company selling products (or services) on credit to thousands of customers will likely have a few customers who will not be able to pay the full amount they owe to the company.

 

By recording an amount in the allowance for doubtful accounts it will also mean that the bad debt expense will be reported closer to the time of the sales—instead of waiting until the account is determined to be uncollectible. Hence, the matching principle is carried out more effectively.

 

The allowance account and the related bad debt expense is encouraged for financial reporting; however, it is not acceptable for income tax reporting. The Internal Revenue Service prefers that any expense for bad debts be deducted later—when an account is actually written off as uncollectible.

 

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The allowance for doubtful account is a balance sheet account that reduces the reported amount of accounts receivable. A change to the balance in the allowance for doubtful accounts also affects bad debt expense on the income statement.

The allowance for doubtful debts is created by forming a credit balance which is netted off against the total receivables appearing in the balance sheet. A corresponding debit  entry is recorded to account for the expense of potential loss.

Once an allowance for doubtful debts has been created, only the movement in the allowance will need to be charged to the income statement in the future accounting period. So if the estimated allowance for doubtful debt is the same as last accounting period no accounting entry will be required in the current period as the  total receivables will be reduced by the amount of allowance which has already been created.

In short the effect on the financial statement is that allowance for doubtful debts is an expense in the income statement and reduces the receivable amount in the balance sheet.