Skip to content
Wikiaccounting
  • Small Business Tools
    • Accounting Software
    • QuickBooks
  • Audit
    • Audit Approaches
    • Assertions
    • Audit Committee
    • Audit Opinion
    • Audit Plan
    • Audit Procedures
    • Financial Statements
    • Audit Risks
    • Internal Audit
    • Audit Sampling
  • Financial Accounting
    • Account Receivable
    • Account Payable
    • Fixed Assets
    • Bank reconciliation
    • Factoring Account Receivable
    • Financial Planning
    • Forensic Accounting
    • Financial Ratios
      • Assets Turnover Ratio
    • Accounting Principle
    • Accounting Documents
    • Financial Statements
      • Balance Sheet
      • Current Assets
      • Equity
  • Small Business Tools
    • Accounting Software
    • QuickBooks
  • Audit
    • Audit Approaches
    • Assertions
    • Audit Committee
    • Audit Opinion
    • Audit Plan
    • Audit Procedures
    • Financial Statements
    • Audit Risks
    • Internal Audit
    • Audit Sampling
  • Financial Accounting
    • Account Receivable
    • Account Payable
    • Fixed Assets
    • Bank reconciliation
    • Factoring Account Receivable
    • Financial Planning
    • Forensic Accounting
    • Financial Ratios
      • Assets Turnover Ratio
    • Accounting Principle
    • Accounting Documents
    • Financial Statements
      • Balance Sheet
      • Current Assets
      • Equity
Wikiaccounting
Search
  • Small Business Tools
    • Accounting Software
    • QuickBooks
  • Audit
    • Audit Approaches
    • Assertions
    • Audit Committee
    • Audit Opinion
    • Audit Plan
    • Audit Procedures
    • Financial Statements
    • Audit Risks
    • Internal Audit
    • Audit Sampling
  • Financial Accounting
    • Account Receivable
    • Account Payable
    • Fixed Assets
    • Bank reconciliation
    • Factoring Account Receivable
    • Financial Planning
    • Forensic Accounting
    • Financial Ratios
      • Assets Turnover Ratio
    • Accounting Principle
    • Accounting Documents
    • Financial Statements
      • Balance Sheet
      • Current Assets
      • Equity

Why is allowance for doubtful debt accounts necessary?

Account Receivable

Introduction:

When a company has a policy of selling goods on credit, a lot of times customers end up not paying the amount they owe to the company.

This expense is referred to as a bad debt expense and its treatment and reporting on the financial statements is a bit raveling.

The International Accounting Standards defines the procedure and methods to record bad debt expense. The Accounting Standards prefer to create a provision for bad debts expense on the basis of organizations past experience.

The estimated may be a percentage of total credit sales or total trade receivables balance. The main logic behind the creation of this provision is to accommodate the bad debts expense in the accounting period which they relate.

In the other methods matching concept is missing which is against the rules of accounting.

Provision for bad debt with example:

The doubt that some invoices are uncollectible is a forecasted expense. For example, there are 2000 customers who owe you an amount of $500,000. You estimate that out of these 2000 customers a few would fail to pay back a total amount of $25,000.

In the present, you don’t know out of the 2000 specifically which customer would fail to pay their dues but a probable expense of $25,000 has been estimated.

This implies that you would be unable to credit the accounts receivable unless you know the customers that are going to default.

In order to deal with this situation instead of waiting for the customers to be identified, a contra asset account is created against the accounts receivable which is also known as allowance for doubtful debt or provision for doubtful debt account. The entry passed to record this procedure is given below:

Bad debt expense DR                  xx

                        Provision for bad debt CR                       xx

The provision for doubtful debt account is created to reduce the accounts receivable balance to its net realizable value without having to credit it.

Related article  Accounting for Direct Write-off Method (Explanation With Examples)

Since it is a contra asset account it has a credit balance as compared to the debit balance of accounts receivable.

It is reported on the balance sheet along with the accounts receivable.  In our example given above, the following entry would have been passed:

Bad debt expense DR                   25,000

                        Provision for bad debt CR                       25,000

Hence, on the balance sheet a net amount of $475,000 would be shown which is the amount expected to be collected from the customers.

Importance of Allowance for Doubtful Debts:

A debit to the bad debt expense account meant that the amount would be reported as an operating expense on the income statement.

The allowance for doubtful debt account lets us report the bad debt expense as soon as the estimate is calculated and help us in portraying a true and fair view of the financial statements.

Let me explain how. The uncollectible invoices of the current year will be reported as bad debt at a later point in the future.

If we report this expense on the income statement at the time defaulting customers are identified this would understate the profit and overstate the expense for that year since the bad debt expense is not related to its revenue.

The bad debt expense is related to the revenue generated in the current year.

Hence in order to achieve the goal of matching principle, bad debt expense or doubtful debts should be recognized as soon as they are expected.

In conclusion, to be able to prepare financial statements as per generally accepted accounting rules, allowance for doubtful debt account must be accordingly maintained.

Related article  What is Accounts Receivable Collection Period? (Definition, Formula, and Example)
Post navigation
← Previous Post
Next Post →

Related Posts

How to Manage Accounts Receivable for Services Industry Company?

Account Receivable

What is Accounts Receivable Collection Period? (Definition, Formula, and Example)

Account Receivable, Financial Accounting

Accounts Receivable Turnover Ratio Analysis: Overview, Formula, And Analysis

Account Receivable, Financial Ratios

Are the Accounts Receivable Current or Non-assets?

Account Receivable, Q$A

Trending

  • Ultimate Guide to Shoprite Pay Stub and W2s For a Current and Former Employee
  • Ultimate Guide To Spotify Pay Stub and W2s For A Current and Former Employee
  • How to Handle 1099-K Forms for Personal Venmo or PayPal Payments?
  • Ultimate Guide to Getting Bank of America Pay Stubs and W2s For a Current and Former Employee
  • Ultimate Guide to Get Bayada Pay Stubs and W2s For a Current and Former Employee
  • HOME
  • ABOUT US
  • POLICIES AND DISCLAIMER
  • CONTACT US
  • ADVERTISE

Copyright © 2023 Wikiaccounting