The allowance for doubtful accounts is a contra-asset that offsets accounts receivable on the balance sheet to reflect expected nonpayment. It represents management's estimate of the portion of receivables that may not be collected.
Under the allowance method, a company records a bad debt expense and increases the allowance in the period revenue is recognized. The typical entry debits bad debt expense and credits allowance for doubtful accounts. When a specific receivable is later deemed uncollectible, the company writes off the amount against the allowance, which reduces both accounts receivable and the allowance without affecting net income at that time.
Cash flow is unaffected by the write-off, but net accounts receivable reported on the balance sheet reflects the allowance. The allowance is a contra-asset, meaning it reduces gross accounts receivable to arrive at net realizable value.
Common approaches include estimating a percentage of the outstanding receivables or using an aging schedule that segments receivables by how long they have been outstanding. The method chosen can affect reported earnings and the perceived risk of collectability.
For example, a company with 500,000 in accounts receivable estimates that 2% may be uncollectible, recording a 10,000 bad debt expense and increasing the allowance by 10,000, which reduces net accounts receivable.
Accounts receivable · Bad debt expense · Allowance method · Direct write-off method · Contra asset · Accrual accounting