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Allowance for Doubtful Accounts, Bad Debt Expense
Definition, Meaning Explained, Example Transactions

 

When a seller learns that one of its business customers has closed suddenly, the seller may conclude that the customer is unlikely ever to pay its outstanding bills. The seller begins the write off process by crediting a contra asset account "Allowance for Doubtful Accounts."

Business firms must face the reality that not all of their customers are going to pay what they owe.

What is allowance for doubtful accounts?

When a business 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 enters the accounting system with two simultaneous transactions.

  • Firstly, the firm debits 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 Net income (Net profit).
  • Secondly, the firm credits a contra asset account, Allowance for doubtful accounts for the same amount. On the Balance sheet, an Allowance for doubtful accounts balance lowers the firm's Net accounts receivable. As a result, the action also lowers the value of Current assets and 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.

Explaining Allowance For Doubtful Accounts in Context

Sections below further define, explain, and illustrate allowance for doubtful accounts. Note especially that the term appears in context with related terms and concepts, including the following:

Doubtful account
Bad debt expense
Write off
Double entry system
Accrual accounting
Inventory write off
Accounts receivable
Asset account
Contra Asset account
Income Statement
Balance Sheet
Cash flow statement

 

Contents

Related Topics


 

Allowance for Doubtful Accounts and Bad Debt
Writing Off Bad Debt

Before there can be a Bad debt expense or Allowance for doubtful accounts, there must be an Account receivable. This is an account owed to an entity, usually by one of its customers as a result of a recent sale or the ordinary extension of credit. A firm that sells and ships goods to a customer, along with an invoice, has an Account receivable until the customer actually pays.

The invoice will state payment terms such as "Net 30," or "Net 60," which means the customer is obligated to pay the balance due no more than 30 or 60 days after receiving the invoice. Payment is overdue if the customer does not pay by the due date.

When Customer Payment is Overdue

When customer payment becomes overdue on an Account receivable, sellers usually notify the customer of the overdue status, and then watch the overdue account for another 30 days, 60 days, or some other time period. During this time the seller continues trying to collect payment.

If payment is still not forthcoming during that period, the seller will choose one of two possible actions:

  • Firstly, continue trying to collect payment.

    This may include intensified collection efforts, such as using a Collection service or a law suit against the non paying customer. These options, however, can raise the cost of collection substantially.
  • Secondly, recognize the debt as a bad debt expense and write off the debt.

    Creditors take this action in the interest of accounting accuracy. A write-off adjusts the sellers Net accounts receivable to reflect the reality. Sellers choose this option when they believe the customer will never pay. This might occur, for instance, when the customer goes out of business or declares bankruptcy.

Transactions in Writing Off Debt

The term, as it appears in this article, is an accounting term. As far as the accounting system is concerned, a write off begins with transactions in two accounts:

  • Firstly, Bad debt expense, a non cash expense account.
  • Secondly, Allowance for doubtful accounts, a contra asset account.

Exhibit 1 below shows how these appear in the journal.

Grande Corporation
Journal for Fiscal Year 20YY
Date AccountDebit
Credit
30-Jun-20YY
30-Jun-20YY
 630  Bad debt expense
 120       Allowance for doubtful accounts
$137,000 
$137,000

Exhibit 1. Journal entries to start the write-off process.

Double entry bookkeeping requires at two transactions for the write off action: 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. Therefore, this account's value increases with a credit (the reverse of the impact a credit has on 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.

Sometimes, customers do ultimately pay the debt, but after the creditor makes the write off transactions. In that case, If the payment comes before the end of the reporting period, the impacts of the initial write transactions can be reversed.

Balance Sheet Reporting Bad Debt Write Off
Balance Sheet Examples

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, the account Allowance for doubtful accounts also appears along with Accounts receivable to adjust its value downwards, as shown in Exhibit 2 below.

Grande Corporation                                   Figures in $1,000's
Balance Sheet at 31 December 20YY   
ASSETS
Current Assets
   Cash
   Short term investments
   Accounts Receivable
      Less allowance doubtful accts
      Net accounts receivable
   Notes receivable short term
   Inventories
      Raw materials
      Work in progress
      Finished goods/merchandise
      Operating & office supplies
            Total Inventories
   Prepaid exp, insurance, def taxes
          Total Current Assets




1,969
   137



    611
1,692
3,664
      19


1,369
  137


1,832
     20





5,986
  265
















9,609
Long Term Investments and Funds
   Common stock held
   Preferred stock held
   Bonds Held / Sinking funds
   Other Long Term Investments
          Total Long Term Investments
    
  493
  184
  364
  419





1,460
Property, Plant & Equipment
   Factory Manufacturing Equipment
      Less accumulated depreciation
      Net factory mfr equipment
   Store Equip / Selling Assets
      Less accumulated depreciation
      Net store/selling equipment
   Computer systems
      Less accumulated depreciation
      Net computer systems
           Total Property, Plant & Equip
 
5,983
 2,782

5,456
 1,292

4,721
 2,370




3,201

4,164


  2,351










9,716
Intangible Assets
   Copyrights
   Trademarks and Patents
   Goodwill
          Total Intangible Assets
    
1,014
108
  100




1,222
Other Assets
                    Total Assets
         68
22,075
LIABILITIES
Current Liabilities
   Accounts payable
   Notes payable, short term
   Current portion of long term debt
   Accrued expenses, Interest payable
   Unearned revenues
   Taxes payable Other withholding
          Total Current Liabilities



 1,642
    912
    349
     146
     274
    141








3,464
Long Term Liabilities
   Bank notes payable
   Bonds payable, other LT liabilities
          Total Long Term Liabilities
                    Total Liabilities
     
912
 4,562



 5,474
8938
OWNERS EQUITY
Contributed Capital
   Preferred stock
   Common stock
   Contributed capital excess of par
          Total Contributed Capital

Retained Earnings
          Total Owners Equity


3,798
4,184
 1,457





9,439

 3,698








13,137
          Total Liabilities and Equities
    22,075
 

Exhibit 2. 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.

Does Allowance for Doubtful Accounts Impact All Financial Statements?

Writing off debt in this way directly impacts two accounting system accounts: Bad debt expense, Allowance for doubtful accounts. Changes in these accounts, in turn, impact other accounts and the firm's accounting statements as follows:

Income Statement Impact

Under accrual accounting, the company claims sales earned during the period, including those that are still "payable." Accounts receivable itself is not an Income statement line item, but the receivable balance is part of the Income statement item Total net sales Revenues.

The Income statement may also include a line item for Bad debt expense. This normally appears under Operating expenses, below the Gross profit line. As a result, Bad debt expense from a write off lowers bottom line Net income.

Balance Sheet Impact.

On the Balance sheet (Exhibit 2), a write off adds to the balance of Allowance for doubtful accounts. And this, in turn, is subtracted from the Balance sheet asset category Accounts receivable. The result is presented as Net Accounts receivable. The write off, in other words means that Net Accounts receivable is lower than Accounts receivable.  

Statement of Changes in Financial Position (Cash Flow Statement)

On the statement of changes in financial position, Bad debt expense appears as a non cash expense item. Bad debt expense from a write off is subtracted from sales revenues, lowering total "Sources of Cash."

Statement of Retained Earnings

Net income (Net profit) from the Income statement makes its way onto the Statement of retained earnings either in the form of dividends paid to share holders, or as retained earnings, or both. Because write off impacts Net income, therefore, the action also lowers dividends and retained earnings on the Statement of retained earnings.