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Key Takeaways
- The allowance for doubtful accounts (ADA) acts as a financial safety net, preparing your business for potential bad debts and ensuring smooth operations.
- Choosing the right ADA calculation method, whether it’s the percentage of sales or AR aging, is crucial for accurate financial planning and risk mitigation.
- ADA is influenced by industry specific conditions and metrics like days sales outstanding (DSO), requiring tailored financial strategies.
- A company debits the bad debt expense and credits the allowance for doubtful accounts to account for potential bad debts.
- Automation streamlines collections, email correspondence, deductions, and payments, helping reduce the number of doubtful accounts.
Introduction
Do you offer credit to your customers and let them pay later? If you answered, yes – you are not alone, it is a common business practice and can help you increase sales by as much as 50%.
But, if you offer a line of credit to your customers, you must pay attention to something called the ‘Allowance for Doubtful Accounts’ (ADA). Establishing an allowance for doubtful accounts is super important for your financial stability.
In this article, we’ll explain what allowance for doubtful accounts is, why it matters, how to calculate it and record the journal entries. So let’s get to it.
What Is an Allowance for Doubtful Accounts?
An allowance for doubtful accounts (uncollectible accounts) represents a company’s proactive prediction of the percentage of outstanding accounts receivable that they anticipate might not be recoverable. In simpler terms, it’s the money they think they won’t be able to collect from some customers.
But why bother predicting this? Well, rather than waiting for customers to default and hit you with unexpected financial hiccups, businesses prepare in advance. They create a cushion known as a “bad debt reserve.” This financial safety net ensures that even if some customers don’t pay up, it won’t disrupt their operations.
The allowance for doubtful accounts resides within the “contra assets” division of your balance sheet. However, contrary to subtracting it, you actually incorporate it into your overall accounts receivable (AR). Why? Because it gives you a more realistic picture of the money you can expect to collect from your customers.
Why is it crucial to create an allowance for doubtful accounts?
It serves two essential functions.
- First, it signals the bad debt expense a company expects to deal with.
- Second, it plays a pivotal role in fine-tuning financial reports, making them more precise and reflective of reality.
So, as we explore further, keep in mind that the allowance for doubtful accounts is not just a financial tool – it’s a vital instrument that helps businesses operate smoothly and report their financial health accurately.
Now, let’s dive deeper into how allowance for uncollectible accounts works with a practical example.
Example of allowance for doubtful accounts
Say you’ve got a total of $1 million in AR, but you estimate that 5% of it, which is $50,000, might not come in. Your net AR, the money you can count on, drops to $950,000.
In their 2021 annual financial report, Microsoft Corporation provided a clear illustration of how to report the allowance for bad debts, demonstrating best practices in financial transparency and accuracy. Here’s the snippet:
Source – Microsoft corporation annual report, 2021
Now that you have got a grasp of what an allowance for doubtful accounts is and why it’s vital for your financial strategy, let’s understand how to calculate it.
How to Calculate the Allowance for Doubtful Accounts?
There are various methods to determine allowance for doubtful accounts, each offering unique insights into the potential risks your accounts receivable might carry. Here’s a breakdown of the two primary methods and some additional strategies used by businesses for allowance for doubtful accounts calculation.
1. Percentage of Sales Method
Simple yet Insightful: This method focuses solely on your credit sales. By analyzing historical data, you can determine a suitable percentage of AR that may go unpaid. This could range from 2% for some companies to 5% for others, based on past performance.
Formula: Allowance for doubtful accounts = (Average expected bad debt * Total accounts receivable)
2. AR Aging Method
Precise and Detailed: Unlike the percentage of sales method, this approach factors in both payment due dates and the duration for which they’ve been pending. Different time windows, like 0-30 days, 30-60 days, and 60-90 days, are considered.
Formula: Allowance for doubtful accounts = (Expected bad debt for aging bucket 1 * Total accounts receivable for aging bucket 1 ) + (Expected bad debt for aging bucket 2 * Total accounts receivable for aging bucket 2 ) + …
3. Other Methods
- Risk Classification Method: Categorizes AR into risk categories (low, medium, high) and calculates ADA based on average pending AR in these categories.
- Historical Percentage Method: Utilizes past data on bad debts to estimate the ADA needed.
- Pareto Analysis: Focuses on analyzing the largest accounts, which typically contribute to 80% of receivables, to identify high-risk accounts. For smaller accounts, the historical percentage method is employed.
What Is the Average Industry-Wise Allowance for Doubtful Accounts?
The allowance for doubtful accounts isn’t a one-size-fits-all metric; it’s influenced by the unique characteristics of different industries. This estimate of expected bad debt expenses isn’t just a random number; it’s closely tied to another important metric—days sales outstanding (DSO). Now, let’s look at the industry-specific ADA benchmarks.
| Industry | Paying current | Up to 30 days late | 30-60 days late | 60-90 days late | 91+ days late |
| Construction | 51.4% | 10.4% | 2.7% | 1.6% | 33.9% |
| Telephone communications | 50.1% | 14.6% | 5.6% | 4.1% | 25.7% |
| Equipment rental/leasing | 42.4% | 11.5% | 16.4% | 15.3% | 14.4% |
| Mfg sheet metalwork | 77.6% | 7.3% | 1.5% | 0.9% | 12.7% |
| Whol drugs/sundries | 64.6% | 13.7% | 4.6% | 5.3% | 11.8% |
Source – Accounts Receivable and Days Sales Outstanding Industry Report, D&B
In essence, DSO serves as a compass for ADA calculation. The higher a company’s DSO, the more cautious it needs to be with its allowance. To make this clearer, let’s look at some real numbers. According to the report from D&B, 78% of customers in the manufacturing sheet metalwork industry pay their bills on time, while in the equipment rental/leasing sector, that figure drops significantly to just 42%. So, the allowance will be lower for the metalwork industry and higher for the equipment rental industry.
This difference shows why it’s crucial to adapt your allowance for doubtful accounts to the specific conditions of your industry.
A company’s allowance for doubtful accounts is directly proportional to its day sales outstanding (DSO).
As we explore the industry-specific benchmarks for the allowance for doubtful accounts, it’s crucial to recognize the broader landscape of credit risk management. Dive into industry insights for a detailed analysis of credit loss to sales ratios among 100 Fortune 1000 companies.
Allowance for Doubtful Accounts Journal Entry
To account for potential bad debts, a company debits the bad debt expense and credits the allowance for doubtful accounts. This journal entry recognizes the estimated amount of uncollectible accounts and establishes the allowance as a contra-asset, meaning it can either be zero or negative.
Here are a few scenarios illustrating the entry of the allowance for doubtful accounts in the balance sheet, presented in a more readable format:
Scenario 1
Suppose a company estimates that it will have $15,000 in bad debt. In this case, the company records a journal entry by debiting the bad debt expense on the balance sheet and crediting the allowance for doubtful accounts.
This means if the net AR of the company is $200,000, the actual payment a business expects to receive is ($200,000 – $15,000 = $185,000).
| Balance sheet | ||
| Account | Debit | Credit |
| Bad debt expense | $15,000 | |
| Allowance for doubtful accounts | $15,000 | |
Scenario 2
Now, imagine that the company wants to write off $10,000 in bad debt. To do so, the company debits the allowance for doubtful accounts and credits the AR. It’s important to note that the net AR remains unaffected, and only the remaining allowance is reduced from $15,000 to $5,000.
| Balance sheet | ||
| Account | Debit | Credit |
| Allowance for doubtful accounts | $10,000 | |
| Accounts receivable | $10,000 | |
Scenario 3
In certain situations, there may be instances where a customer is initially unable to pay, resulting in their AR being written off as bad debt. However, after a few weeks or months, the customer manages to make the payment and clear their dues. In such cases, the business follows a specific process.
Firstly, the company debits its AR and credits the allowance for doubtful Accounts. Then, a subsequent journal entry is made by debiting cash and crediting AR.
| Balance sheet | ||
| Account | Debit | Credit |
| Accounts receivable | $5,000 | |
| Allowance for doubtful accounts | $5,000 | |
| Cash | $5,000 | |
| Accounts receivable | $5,000 | |
We hope by examining these scenarios, you can gain a clear understanding of how the allowance for uncollectible accounts is recorded on the balance sheet and its effect on the company’s financial position.
How Can Automation Help Reduce the Number of Doubtful Accounts?
In the ever-evolving landscape of modern business, agility and efficiency are paramount. Manual processes, while once the norm, can now be a bottleneck leading to missed opportunities and increased risks. This is where automation comes into play, emerging as the ultimate solution to transform your operations and supercharge your collections strategy.
Source: PYMNTS
Being proactive with your collections process is the easiest way to reduce the number of doubtful or delinquent accounts. A reliable collections automation solution can help you achieve better cash flow, lower bad debt, and improve profits by analyzing customer behavior, risk, and past data.
Automation can help by:
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Prioritizing collections: Automation brings the power of data to your collections strategy. By automatically assessing various factors like past due amounts, promise-to-pay violations, customer credit risk, and more, it assigns a collections score to each customer.
This data-driven approach helps you identify which accounts need attention most urgently and allows you to customize your collections strategies in order of priority.
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Streamlining email correspondence: Automation takes the hassle out of email correspondence. It not only sends past-due notices and proactive reminders to customers but also keeps a close eye on the status of these emails.
Moreover, it processes customer emails, generating tasks for your collector, such as a promise to pay, a reminder to follow up, or a dispute
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Managing deductions effectively: With automation, handling deductions becomes a breeze. It automatically generates a dispute for a specific invoice, assigns an appropriate reason code from ERP reason codes, and attaches necessary backup documents.
The system then evaluates the validity of the dispute based on this information and ensures every dispute is handled swiftly and accurately, minimizing revenue leakage.
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Enabling in-app payments: Automation simplifies the payment process by embedding a payment link directly in your correspondence. This allows your customers to initiate digital payments effortlessly with just a click. It provides a shortcut to convenience, ensuring a seamless and hassle-free payment experience.
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Real-time data and analytics: Informed decisions are the bedrock of effective financial management. Automation provides you with real-time data and actionable insights, empowering you to make decisions that can prevent accounts from going doubtful in the first place.
But how do you harness the power of automation effectively?
That’s where HighRadius steps in. We offer not just automation but a complete transformation of your collections processes.
With the RadiusOne AR Suite tailored for mid-market businesses and AI-based Collections Software designed for large enterprises, we’re here to revolutionize your financial operations, safeguard your bottom line, and ensure your business thrives in the face of uncertainty.
Discover how HighRadius can turn your financial goals into reality. Schedule a demo today and witness the future of financial management in action.
FAQs on Allowance for Doubtful Accounts
1. What is the purpose of doubtful accounts?
The purpose of doubtful accounts is to prepare for potential bad debts by setting aside funds. It ensures a company’s financial stability, preventing disruptions in case customers can’t pay their debts.
2. Is allowance for doubtful accounts the same as bad debt expense?
No, allowance for doubtful accounts and bad debt expense are not the same. The allowance is an estimated reserve for potential bad debts, while bad debt expense is the actual amount recognized as a loss when a specific account is deemed uncollectible.
3. When should you write-off bad debt?
You should write off bad debt when it’s clear that a customer won’t pay, typically after exhaustive collection efforts. Writing it off removes the debt from your accounts receivable, reflecting the loss accurately.
4. What type of account is an allowance for doubtful accounts?
An allowance for doubtful accounts is considered a contra-asset account. It is deducted from the total accounts receivable on the balance sheet to show a more realistic picture of expected collectible amounts.
5. Is allowance for bad debts an asset?
Yes, allowance for bad debts is considered an asset on the balance sheet. It’s a contra-asset that offsets accounts receivable, reflecting potential losses.
6. What happens if bad debt exceeds allowance?
If bad debt exceeds the allowance, it indicates potential financial strain. The company may need to adjust its allowance, recognizing a higher risk of uncollectible accounts.
7. What is an allowance for bad debts?
Allowance for bad debts is a financial reserve that a company sets aside to cover potential losses from customers who may not pay their outstanding debts. It acts as a safeguard against unexpected revenue shortfalls.
8. Is allowance for doubtful accounts a debit or credit?
Allowance for doubtful accounts is a credit. It reduces accounts receivable to reflect the amount expected to be uncollectible. This adjustment helps maintain accurate financial records by accounting for potential bad debts.
