Allowance for Doubtful Accounts

What is an allowance for doubtful accounts? Let's try and understand this concept in a step-by-step manner. We all know about bad debts. Our business gives money to another business or a person, which is known as debt. And when our 'debtor' does not pay us back, the business debt is said to have gone bad. A bad debt is a business loss. But then what are doubtful debts?

What is Allowance for Doubtful Accounts?
The conservatism principle of accountancy teaches us to not anticipate any profits and be prepared to face business losses. Hence, is the requirement to make an allowance for doubtful accounts in accordance with this principle. A doubtful debt allowance is exactly what it sounds! It is buffer against any loss that may be incurred due to the non-payment by business debtors. It is an amount of money put aside by the business, to deal with the losses that may arise when the debtor is displays his inability to pay up.

Apart from this, maintaining allowance for doubtful debts accounts is a requirement as per the U.S. GAAP. The Generally Accepted Accounting Principles (GAAP) lays down the requirement for creating an allowance for doubtful debts, in accordance with the matching principles along with the conservatism principle.

How to Make the Allowance for Doubtful Accounts Entry?
Let's brush up some of our basic accounting knowledge, before proceeding to the matter of journal entry and allowance for doubtful accounts balance sheet posting. We know that there are three classes of accounts: real, personal and nominal. Most people wonder if the allowance for doubtful accounts liability is correct. Actually, the allowance for doubtful debts account falls under the category of contra-asset account. A contra asset account is a type of account that reduces the value of an asset account. Hence, the entry for this account will be such that it will reduce the value of the accounts receivable account. The accounts receivable account is a personal account. The rule for personal account journal entry is debit the receiver and credit the giver. As the debtor not paying up will reduce the debit balance of the account receivable, it will be credited.

For the sake of this example, let us assume that the sales for the year have been $100,000. If you fix the allowance for doubtful accounts at 5% of total sales, then the amount you will be putting in the allowance account is $5,000. Now, recalling the rules mentioned in the above paragraph, the entry will be:

Allowance for Bad Debts A/c..............Dr. $5,000
To Accounts Receivable A/c...............Cr. $5,000

Now once this entry is made, you have prepared your allowance for doubtful accounts. Normal balance for the same will be continued in the next accounting periods. Once this account is ready, you will make the entries for the bad debts that happen in the following way. For the sake of this example, let us assume that there was a bad debt of $300.

Bad Debts A/c ….................................Dr. $300
To Allowance for B.D. A/c....................Cr. $300

For the meaning of more such accounting terms, read glossary of accounting terms and definitions.

Hopefully, I have made the concept of allowance for doubtful accounts fairly easy to understand. Allowance for doubtful accounts flummoxes the best accounting students, so you're not the only one facing a problem learning this concept! When it comes to accounts, it is essential that you have your basics right. Once you have them clear in your mind, any entry can be easily done.