Allowance for Doubtful Accounts



Module 3:
Cash, Receivables, Payables

Duration:
45-60 minutes

Level:
Beginner to Diploma-Level


Lesson Objectives

➛ Understand why bad debts occur

➛ Explain the Allowance for Doubtful Accounts concept

➛ Apply the matching principle

➛ Record journal entries for estimating uncollectible accounts

➛ Distinguish between Direct Write-Off and Allowance Method


What Are Doubtful Accounts?

Not all customers pay what they owe. Some accounts receivable may become uncollectible.

These uncollectible receivables are called bad debts or doubtful accounts.


Why Do We Need an Allowance?

Accounting follows the matching principle, which means

Expenses should be recorded in the same period as the related revenue.

➛ Sales are recorded before cash is collected
➛ Some receivables may not be paid
➛ We must estimate losses in advance

That’s why we use an Allowance for Doubtful Accounts.


Allowance for Doubtful Accounts

➛ A contra-asset account
➛ Reduces Accounts Receivable
➛ Shows the estimated amount that may not be collected

On the balance sheet

Accounts Receivable
Less: Allowance for DA
Net Accounts Receivable

xxx
xxx
xxx



Two Methods of Handling Bad Debts

1. Direct Write-Off Method
➛ Bad debt is recorded only when a customer fails to pay
➛ Violates the matching principle
➛ Not allowed under GAAP

Journal Entry

Bad Debt Expense
Accounts Receivable

Dr
Cr



2. Allowance Method | Preferred
➛ Bad debts are estimated in advance
➛ Matches expense with revenue
➛ Required by GAAP


Estimating Bad Debts | Overview

There are two common estimation approaches

1. Percentage of Sales Method
2. Aging of Accounts Receivable | covered in next class

In this class, we focus on the concept, not aging details yet.


Journal Entry for Estimating Bad Debts

At the end of the accounting period

Bad Debt Expense
Allowance for Doubtful Accounts

Dr
Cr



➧ Increases expenses
➧ Increases allowance | contra-asset


Writing Off an Uncollectible Account

When a specific customer account is confirmed as uncollectible

Allowance for Doubtful Accounts
Accounts Receivable

Dr
Cr



No effect on expenses at this stage | already estimated earlier.


Key Takeaways

➛ Allowance for Doubtful Accounts is an estimate
➛ It ensures accurate profit reporting
➛ It improves the quality of financial statements
➛ Uses judgment and historical data


Quick Quiz

➛ What is the purpose of the allowance for doubtful accounts?

➛ Why is the direct write-off method not acceptable under GAAP?

➛ Is the allowance account an asset, liability, or expense?

➛ Which principle is satisfied by the allowance method?

➛ Write the journal entry to record estimated bad debts.

Answers ➧ Here

Aging of Accounts Receivable ➧ Here