App version: 0.1.0

What Is Allowance for Doubtful Accounts?

What Is Allowance for Doubtful Accounts?
Susan Guillory
Susan GuilloryUpdated September 13, 2022
Share this article:
Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
As a small business owner, you expect to collect on every invoice you send. Unfortunately, that’s not always how things work out. Some customers may dispute invoices, while others may simply go belly up. Allowance for doubtful accounts helps business owners account for the reality that some invoices may go unpaid. Read on for a closer look at what allowance for doubtful accounts is, how to calculate this allowance for your business, and how it can impact your balance sheet.

How Allowance for Doubtful Accounts Works

Allowance for doubtful accounts “allows” for the reality that a business may have trouble collecting payment from some clients due to disputes, miscommunications, or a customer experiencing insolvency. Rather than wait to see exactly who pays and who doesn’t, the company will debit a bad debt expense and credit allowance for doubtful accounts.Allowance for doubtful accounts is an estimate, not a hard number. It is based on an educated guess about how much of a company’s total accounts receivable may be uncollectible. While there is still a chance you will receive the money, this allowance helps companies more accurately estimate the actual value of their account receivables. Once actual payment is known for accounts receivable and default payments, the balance sheet can be updated accordingly.  According to the generally accepted accounting principles (GAAP) , the allowance for doubtful accounts should be recorded in the same accounting period as the sale. This ensures that expenses related to the sale are recorded in the same period as the revenue is earned.Keep in mind that allowance for doubtful accounts is not the same thing as unearned revenue. By contrast, unearned revenue is money received by a company for a service or product that has yet to be provided or delivered. It is recorded on a company's balance sheet as a liability because it represents a debt owed to the customer.

Allowance for Doubtful Accounts for Different Industries

Some industries have a higher allowance for doubtful accounts than others. Publishing and nonresidential construction, for example, have a high percentage of invoices paid 90 days or later, which results in a higher allowance for doubtful accounts.Generally, the longer your collection cycle, the greater your allowance for doubtful accounts should be. However, every business is unique. To determine your allowance for doubtful accounts, it can be helpful to research typical payment behavior in your company’s industry. 

Calculating Allowance for Doubtful Accounts

So how do you calculate the allowance for doubtful accounts? There are a few different methods you can use.  

1. Percentage of Sales

This method is based on historical data and applies a flat percentage to the total dollar amount of sales for the period. If your company sees that, on average, 5% of sales made on credit are not being paid, you can use this estimate for your allowance. 

2. Aging Method for Accounts Receivable

With this method, all outstanding accounts receivable are grouped by age, and specific percentages are applied to each group. You can determine these percentages based on previous experience. For example, maybe 2% of accounts receivable less than 30 days old will be uncollectible, and 5% of accounts receivable at least 30 days old will be uncollectible. You then apply the expected default rate to each age group.

3. Risk Classification

Another option is to assign a risk score to each customer that identifies the likelihood that they will not pay their accounts receivable. The higher the score, the greater the risk of default on payment.You can come up with a risk score by looking at historical payment collection data for each customer and calculating the percentage of invoices they typically default on. 

4. Pareto Analysis

The Pareto principle states that about 80% of consequences come from 20% of causes. In this case, you can look at the accounts you have that make up 80% of your total accounts receivable and estimate which customers are most at risk of not paying. You can then use historical data to calculate the remaining 20%.This method can work well if you have a small number of large account balances.

Where Allowance for Doubtful Accounts Goes on a Balance Sheet

Is allowance for doubtful accounts an asset? No. Allowance for doubtful accounts is not classified as an asset (since it does not represent long-term value), nor is it classified as a liability, since it does not represent a future obligation.When it comes to allowance for doubtful accounts on the balance sheet, it is listed as a deduction immediately below the accounts receivable line item. This deduction is classified as a contra asset account.

Example of Allowance for Doubtful Accounts

Here’s an example of how to calculate allowance for doubtful accounts using the aging method. Let’s say company XYZ has 90 customers who purchase on credit and the total amount owed is $900,000. The $900,000 will be reported on the balance sheet as accounts receivable.To calculate allowance for doubtful accounts, XYZ will group all outstanding accounts receivable by age and apply a specific percentage to each group. In this case, the company has determined that, based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and this amounts to $8,000. It does this calculation for each age group as follows:
  • 0-30 days: $8,000
  • 31-60 days: $20,000
  • 61-90 days: $15,000
  • 90+ days: $10,000
  • Total: $53,000
XYZ’s balance sheet would have $53,000 as a debit for bad debts expense, and a credit of $53,000 for allowance for doubtful accounts.With the account reporting a credit balance of $53,000, the balance sheet will report a net amount of $9,950,000 for accounts receivable. This is the amount that is likely to be turned into cash. The debit to bad debts expense would report credit losses of $53,000 on XYZ’s income statement.

Bad Debt Expenses vs Allowance for Doubtful Accounts

A bad debt expense is a receivable that is no longer collectible because a customer is unable to pay its outstanding debt due to bankruptcy or other financial problems. Bad debt expenses are typically classified as a sales and general administrative expense and are found on the income statement.Allowance for doubtful accounts is the amount of accounts receivable estimated to be later written off as uncollectible. It is a contra asset, which means it decreases the dollar amount of the asset with which it is paired. In the case of allowance for doubtful accounts, the asset is paired with accounts receivable and reduces its value on the balance sheet.

The Takeaway

Non paying customers are a reality for most businesses. The allowance for doubtful accounts helps you account for these risks and provide a more realistic picture of your accounts receivable on your balance sheet.Understanding how to calculate allowance for bad debt can give you a more accurate picture of your company’s cash flow. This, in turn, can help you determine whether you are generating enough capital to cover expenses and invest in new opportunities, or whether it makes sense to apply for a small business loan or line of credit to cover shortfalls and/or expedite business growth.

3 Small Business Loan Tips

  1. Online lenders generally offer fast application reviews and quick access to cash. Conveniently, you can compare small business loans by filling out one application on Lantern by SoFi.
  2. If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.
  3. SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.

Photo credit: iStock/ArtistGNDphotography
LCSB0722002

Frequently Asked Questions

Is allowance for doubtful accounts considered an asset?
How do you record allowance for doubtful accounts on a balance sheet?
Is allowance for doubtful accounts a debit or credit account?

About the Author

Susan Guillory

Susan Guillory

Susan Guillory is the president of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.
Share this article: