How to Calculate Allowance for Doubtful Accounts

Almost all companies make an allowance for Doubtful Accounts to adequately cope with a situation where a debtor is not able to make payments. This could be due to financial hardship, dispute or even bankruptcy. Rather than waiting for the money to pop up from somewhere, a company records the transaction by following the GAAP principles.

Instructions

  • 1

    To account for bad debts, a company has two approaches at its disposal. One is commonly referred to as the sales approach which will use a percentage of the total sales to compute the bad debts amount. The other refers to the accounts receivable approach which calculates the final amount by taking a percentage of accounts receivable.

  • 2

    For accounting purposes, a journal entry is recorded in the two general ledger accounts, which will be referred to as a bad debt expense account, and allowance for doubtful account. Irrespective of the method applied, the former will have a debit entry, while the latter will have a credit entry. Allowance for doubtful account is known as a contra-asset account, which is used to subtract a related amount from an asset account, which in this case is accounts receivable.

  • 3

    In the first approach, a company will look at the historical data and determine a percentage of its sales which they feel will not be collected. So for instance, if a company has reported sales of $1000, and has set 2% for sale uncollectible, then by multiplying the two values, it will know that $20 of the sales revue will go unpaid. By establish that in the books, it will debit the bad expense account $20, and credit the same amount in the Allowance for Doubtful Accounts.  Here any outstanding balance in the Allowance account will not be considered.

  • 4

    Now look at the other approach. Assume that the company has decided that 2% of the accounts receivable will go uncollected. If the A/R’s balance is 2000, the journal entry to record this expense will be to report the Bad debt Expense as $40 (2000 x 0.02) and credit the Allowance account $40. As opposed to the sales approach, any previous amount in the allowance account will be carry forward and the entries will be adjusted accordingly.

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