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Allowance for Doubtful Accounts

Allowance for Doubtful Accounts

Most students of accountancy falter on the topic of allowance for doubtful accounts. The article below attempts to throw some light on the same.
Arjun Kulkarni
Last Updated: Jun 3, 2018
Bad debts are something all of us are aware of. When a business lends money to another business or a person, it is known as a debt. The debtor is required to repay the amount after a certain period, and if he does not, the debt is said to have gone bad. And obviously, a bad debt is a business loss. Then, where does the query of doubtful debts creep in? The paragraphs below will elaborate on this topic.

The Concept
  • The conservatism principle of accountancy teaches us to not anticipate any profits and be prepared to face business losses. Thus, it is the requirement to make an allowance for it in accordance with this principle.
  • A doubtful debt allowance is exactly what it sounds like; it is a 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 the allowance for such 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.
Making an Entry for a Doubtful Account
  • Prior to proceeding to the matter of journal entry and doubtful accounts balance sheet posting, you need to understand the term 'accounts'.
  • There are three classes of accounts - real, personal, and nominal.
  • Most people wonder if the liability for any allowance for doubtful accounts is correct. Actually, the allowance 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.
Example

Assume that the sales for the year have been USD 100,000. If you fix the allowance for the doubtful account at 5% of total sales, then the amount you will be putting in the allowance account is USD 5,000. Now, recalling the rules mentioned in the above paragraph, the entry will be:

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

Now once this entry is made, you have prepared your allowance. 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 USD 300.

Bad Debts A/c - Dr. USD 300
To Allowance for B.D. A/c - Cr. USD 300

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

Hopefully, I have made the concept fairly easy to understand. It indeed 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.