When it comes to your small business, you don’t want to be in the dark. Your accounting books should reflect how much money you have at your business. If you use double-entry accounting, you also record the amount of money customers owe you. But, what happens if they don’t pay? To protect your business, you can create an allowance for doubtful accounts.
What is allowance for doubtful accounts?
An allowance for doubtful accounts, or bad debt reserve, is a contra asset account (either has a credit balance or balance of zero) that decreases your accounts receivable. When you create an allowance for doubtful accounts entry, you are estimating that some customers won’t pay you the money they owe.
When customers don’t pay you, your bad debts expenses account increases. A bad debt is debt that you have officially written off as uncollectible. Basically, your bad debt is the money you thought you would receive but didn’t.
In addition to bad debt, there’s such a thing as doubtful debt. Unlike bad debt, doubtful debt isn’t officially uncollectible debt. Doubtful debt is money you predict will turn into bad debt, but there’s still a chance you will receive the money.
Use an allowance for doubtful accounts entry when you extend credit to customers. Although you don’t physically have the cash when a customer purchases goods on credit, you need to record the transaction.
Use the accrual accounting method if you extend credit to customers. If a customer purchases from you but does not pay right away, you must increase your Accounts Receivable account to show the money that is owed to your business.
If a customer never pays you, the unpaid payments become bad debts. And, having a lot of bad debts drives down the amount of revenue your business should have. ADA accounting helps increase the accuracy of your books. By predicting the amount of accounts receivables customers won’t pay, you can anticipate your losses from bad debts.
A reserve for doubtful debts can not only help offset the loss you incur from bad debts, but it also can give you valuable insight over time. For example, your ADA could show you how effectively your company is managing credit it extends to customers. It can also show you where you may need to make necessary adjustments (e.g., change who you extend credit to).
Allowance for doubtful accounts on the balance sheet
When you create an allowance for doubtful accounts, you must record the amount on your business balance sheet.
Because an allowance for doubtful accounts is a contra asset that reduces your accounts receivables, you record it under assets. It may look something like this:
Assets Cash: 500 Accounts receivable: 2,000 Less allowance for doubtful accounts: (200)
If the doubtful debt turns into a bad debt, record it as an expense on your income statement.
Allowance for doubtful accounts calculation
For many business owners, it can be difficult to estimate your bad debt reserve. There are a few different ways you can calculate your predictions.
You can make your predictions based on historical data. Use the percentage of bad debts you had in the previous accounting period to help determine your bad debt reserve.
For example, if 3% of your sales were uncollectible, set aside 3% ofContinue reading