What is allowance for doubtful accounts?
When a company decides to write off an account payable owed it as bad debt, it creates a bad debt expense. This is the accountant's method for adjusting accounts in the interest of accounting accuracy.
The bad debt expense is registered in the accounting system with two simulataneous transactions.
- A debit transaction is applied to a non-cash expense account, bad debt expense. This expense along with other expenses will be subtracted from sales revenues on the income statement, thereby lowering reported profits.
- A credit transaction for the same amount is applied to a contra asset account, allowance for doubtful accounts. On the balance sheet, allowance for doubtful accounts is applied to lower acounts receivable, thereby lowering the value of total assets.
The examples below further explain how a company writes off bad debt and how these accounts impact each other. The discussion also examines the impact of writing off bad debts on the income statement, balance sheet, and statement of changes in financial position.
- What is allowance for doubtul accounts?
- Examples: Which kinds of transactions are involved in writing off bad debt?
- Balance sheet example of bad debt write off.
- What is the impact of allowance for doubtul accounts on financial statements?
Writing off bad debt example transactions
Before there can be a bad debt expense or allowance for doubtful accounts, there must be an account receivable. An account receivable is an amount that is owed to an entity, usually by one of its customers as a result of a recent sale or the ordinary extension of credit. A company that has sold and shipped goods to a customer, and sent an invoice, has an account receivable if the customer has not actually paid yet. The invoice will state payment terms such as "net 30," or "net 60," which means the customer is obligated to pay the net balance due no more than 30 or 60 days after receiving the invoice. The customer is overdue if payment is not made by the due date.
When customer payment becomes overdue on an account receivable, the selling company will usually notify the customer of the overdue status and then watch the overdue account for another 30 days, or 60 days, or some other time period, during which it continues attempting to collect payment. If payment is still not forthcoming, or if the seller has other reason to believe it will never be paid (e.g., the customer has gone out of business or declared bankruptcy), the seller may choose to "write off" the debt, as shown below. To do so, the bookkeeper will make two entries in the journal that might look like this:
Journal for Fiscal Year 20YY
| 630 Bad debt expense
120 Allowance for doubful accounts
Double entry bookkeeping requires two entries for every transaction, one a debit and the other an equal, offsetting credit. Here, the account Bad debt expense is a normal expense category account whose balance increases with a debit transaction. The other account, Allowance for doubtful accounts is an asset category account, but it is also a contra asset account. Thus, this account's value is increased by a credit (the reverse of what a credit does to a normal asset account).
Writing off the debt this way, incidentally, does not relieve the debtor of the obligation to pay. The seller undertakes the write off in the interest of accounting accuracy, but the customer is still liable for the debt. The seller retains every right to pursue payment by other legal means, such as engaging a collection service or filing a law suit.
Examples: Which kinds of transactions are involved in writing off bad debt?
At the end of an accounting period, when financial accounting reports are prepared and published, the sum of receivable accounts appears on the Balance Sheet as Accounts receivable. However, another account, Allowance for doubtful accounts, also appears along with Accounts receivable to adjust its value downwards, as shown in the example below.
Doubtful accounts appear on the Asset side of the balance sheet under Current assets:
See the encyclopedia entry balance sheet for a more detailed version of the above sheet. For working examples of interrelated financial statements and a full coverage of financial statement metrics, see Financial Metrics Pro.
What is the impace of allowance for doubtful accounts on financial statements?
With the write off accomplished this way, the impacts on Accounts receivable, Bad debt expense, and Allowance for doubtful accounts on the financial statements are as follows:
- Income statement and statement of changes in financial position: The Accounts receivable figure is part of the total Net Sales Revenues. Under accrual accounting, the company claims sales earned during the period, including those that are still "payable"
Both of these statements, however, may include a line item for Bad debt expense. On the income statement this normally appears along with other expenses under Operating expenses, below the Gross profit line. On the statement of changes in financial position, Bad debt expense will be listed as a non cash expense. In both cases, the net result is to adjust the Sales revenues contribution downward.
- Balance Sheet: On the balance sheet (as shown in the example), the asset category account Accounts receivable has its impact adjusted downward by the contra asset account Allowance for doubtful accounts.