Definition: Allowance for doubtful accounts is a simple one-line calculation that provides a ready-to-use estimate of the percentage of your receivables that will never be paid.
Accounts receivable refers to unpaid debts that have a chance of being paid through a future payment. Most business accounts receivable are short-term in nature, typically accruing from sales revenue that is not yet disbursed. When accounting for uncertain payments in future periods, such as debts that have matured or balances that may never be paid, the allowance for doubtful accounts is usually accumulated as a reduction to current liability rather than an increase to the amount outstanding.
Allowance for doubt is generated when a company’s internal projections are higher than the actual value of the receivables reflected on the balance sheet. An allowance for doubt is a valuable tool to have in your business arsenal because it gives you an element of uncertainty around your actual debt obligations; it gives you a chance to successfully negotiate with debtors and obtain favorable terms on any disputed accounts, knowing that there is a greater than the expected probability that your actual debt obligations will not be paid off in full.
Allowance for doubtful accounts presents a challenge because, when major accounts are settled, there can be a delay in realizing the net settlement amount due on disputed accounts. This can result in inadequate financial planning for the remaining balance on accounts with uncertain outcomes. To avoid this, companies should review accounts regularly and consider adopting certain policies for accounts with doubtful relations to major accounts.
Allowance for Doubtful Accounts Calculation
There are two ways to calculate allowance of debts
- The percentage of sales method provides an accurate but not exact representation of the amount of money that could be subject to receivable when making a sale.
- The aging method relies on calculating the average of one month’s worth of sales for each year of forecasted sales history. When the average of one month’s worth of sales becomes unavailable, an adjustment is made to the amount outstanding. As a result, some uncertain accounts may remain as estimates, and others could increase or decrease in the final calculation as new information is received.
The allowance for doubtful accounts is a simple guideline for responding to changing business circumstances. Unless business prospects materially change the accounting assumptions that form the basis of current accounting estimates, an account receivable that meets the allowance criteria may not be receivable. Accounting for doubtful accounts accurately allows business owners to plan for sales revenue while minimizing their risk of over-or understating revenue. In practice, this means using a percentage of sales rather than an absolute number for the estimated number of accounts receivable.
Allowance for doubtful accounts is a mechanism that encourages customers to continue paying their bills even when accounts become questionable. This feature helps establish good credit repair habits early in a customer’s account history. The benefit is that allowance for doubtful accounts provides customers with a predictable discount on outstanding balances and reduces the chance that an account will be failed over to collections by creditors without the opportunity to make good on their past payments.