Doing business is synonymous with taking risks – and success in business depends on effectively defining, anticipating and mitigating those risks. For firms that sell on credit and use the accrual method of accounting, an allowance for doubtful accounts (also known as an “ADA” or a “bad debt reserve”) can be a valuable risk-management tool that enhances the accuracy of its financial statements.
What is Allowance for Doubtful Accounts?
Instead of being caught off guard by delinquent customer payments and risking a cash flow squeeze, businesses can use an allowance for doubtful accounts (ADA) to make data-driven predictions about how many sales are likely to become bad debts. From there, they can adjust their balance sheet to better reflect the true value of their accounts receivable.
What is the Purpose for Allowance of Doubtful Accounts?
No matter how stringent a firm’s credit policies are, there is always a chance that some of their customers won’t pay up. Even companies with excellent credit histories are susceptible to disruption or failure at some point in the future – or they could dispute an invoice. That creates the possibility that you won’t be paid.
In establishing an allowance for doubtful accounts, businesses quantify this nonpayment risk across all their credit sales within a given period, and then they list this dollar figure on the balance sheet as a contra-asset. A contra asset is an asset account with a credit balance that offsets a related asset account with a debit balance. In this case, the ADA offsets accounts receivable. So, when the ADA goes up, accounts receivable goes down, as do total assets.
In keeping with Canadian and international Generally Accepted Accounting Principles (GAAP), the ADA is recorded simultaneously with sales. Since the ADA is an estimate, not an actual tally of bad debt, firms can continuously refine their computational method as they gain actual payment data. This way, firms can obtain a more complete picture of revenue and expenses, enabling better budgeting and management of working capital.
How to Calculate Allowance for Doubtful Accounts
There are several ways to calculate the allowance for doubtful accounts. Let’s take a look at five key approaches currently in use.
Percentage of Sales Method
The percentage of sales method estimates bad debts as a proportion of total credit sales.
For example, based on previous experience or industry benchmarks, Firm A might decide to apply a flat 2% to all credit sales. So, if credit sales for a given period total $200,000, the firm would establish an allowance for doubtful accounts in the amount of $4,000. The calculation looks like this:
Credit Sales × Bad Debt Percentage = ADA
AR Aging Method
The accounts receivable aging method categorizes receivables by how long they’ve been outstanding.
This calculation is slightly more complex than simply applying a flat percentage. However, it can yield more accurate results. For example, suppose Firm B determines that 5% of its invoices that are under 45 days overdue (Bucket I) will become bad debts, but 15% of invoices that are over 45 days overdue (Bucket II) will become bad debts. In a given period, receivables in Bucket I total $40,000 while receivables in Bucket II total $20,000. They can then use this formula:
(Probability of Bucket I Default × Bucket I Total) + (Probability of Bucket II Default × Bucket II Total) = Allowance for Doubtful Accounts
(0.05 × $40,000) + (0.15 × $20,000) = $5,000
Risk Classification Method
The risk classification method assigns a probability of nonpayment to each client (or type of client) based on creditworthiness and other factors.
As a highly simplified example, let’s suppose that Firm C has only two clients: Firm D and Firm E. Firm D has been in business for 25 years and has a business credit score of 85 while Firm E has been in business for only three years and has a business credit score of 40. Based on this data, Firm C estimates that Firm D has a 1% chance of nonpayment and that Firm E has a 10% chance of nonpayment. In a given period, they have extended Firm D $50,000 in trade credit and Firm E $20,000 in trade credit. They can then use this formula:
(Probability of Firm D Default × Firm D Credit Total) + (Probability of Firm E Default × Firm E Credit Total) = Allowance for Doubtful Accounts
(0.01 × $50,000) + (0.10 × $20,000) = $2,500
Historical Percentage Method
The historical classification method leverages past payment data to forecast future bad debts.
Often, this is a form of the percentage of sales method (discussed above) in which the flat rate is based on the firm’s own track record of bad debt losses.
For example, based on the last five years of payment data indicating that 3% of credit sales eventually became bad debts, Firm F might decide to apply a flat 3% to all credit sales. So, if credit sales for a given period total $300,000, the firm would establish an allowance for doubtful accounts in the amount of $9,000.
Pareto Analysis Method
The Pareto analysis method aims to identify a few accounts that represent a disproportionate amount of risk.
Business managers may be familiar with the Pareto principle as it applies to sales: 80% of sales typically come from 20% of clients. Likewise, some have suggested that the Pareto principle applies to bad debts, as well. This approach can’t be used to determine an allowance for doubtful accounts on its own, but the concept of differentially weighting a subset of high-risk customers can be applied to other computational methods.
Accounting for Allowance for Doubtful Accounts
Firms should establish a process and methodology to determine ADA for current and prospective clients. This can mitigate risks, as well as offer an accurate system of record keeping which may inform future decisions.
Establish What the Allowance for Doubtful Accounts Is
As mentioned above, the allowance for doubtful accounts is a contra account that’s paired with accounts receivable on the balance sheet. But the ADA also has a corresponding entry on the income statement: bad debt expense. When it becomes clear that a certain payment cannot be collected, the company will debit the bad debt expense account and credit the ADA.
After choosing a method of calculation and ensuring that all the associated line items appear on their respective financial statements, a firm will be ready to put the ADA to work.
Writing Off Doubtful Accounts
The allowance for doubtful accounts is only a forecast of future bad debts, and eventually, businesses will have to deem certain accounts uncollectible and write them off. In the context of business bookkeeping, a write-off is when a business permanently removes a receivable from its financial records.
Suppose that Firm G owes Firm H $5,000, and after various collection attempts, Firm H deems that item bad debt. If Firm H doesn’t have an ADA, they might use the direct write-off method: debiting bad debt expense by $5,000 and crediting accounts receivable by the same amount. However, if Firm H has an ADA, they would use the allowance method: debiting the ADA by $5,000 and crediting accounts receivable bythe same amount. (Since the expense was recognized when the ADA was created, this action isn’t reflected on the income statement.)
FAQs
Is Allowance for Doubtful Accounts an Asset?
Allowances for doubtful accounts are contra assets, not assets. They are reported under current assets on the balance sheet.
Is Allowance for Bad Debts a Credit or Debit?
Allowances for doubtful accounts are contra assets that have natural credit balances. They can be both credited (to increase the allowance) or debited (to write off specific items).
Is Allowance for Doubtful Accounts a Temporary Account?
Allowances for doubtful accounts are categorized as permanent accounts because they get carried into the next accounting period.
Protect Yourself from Non-Payment With Trade Credit Insurance
Establishing an allowance for doubtful accounts is just one of many smart risk-management strategies that businesses can pursue. With trade credit insurance from Allianz Trade Canada, firms can enjoy additional protection from bad debts, secure more capital and safely grow sales with new and existing customers.
