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Allowance for Doubtful Accounts: Examples and Explanation

written by: ciel s cantoria•edited by: Linda Richter•updated: 8/21/2010

This article features a valuation tool called Allowance for Doubtful Accounts. Examples and explanations provided dwell on the use and significance of this contra-asset account. Its estimations do not change the receivables balance but can alter the net worth represented by the balance sheet.

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    The Importance of Recognizing a Valuation Reserve via Allowance for Doubtful Accounts

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    The objective of this article is to convey the use and significance of recognizing a valuation reserve using the Allowance for Doubtful Accounts. Examples and explanations presented in the succeeding sections aim to illustrate how the valuation reserve concept is translated into actual use. It is important that we should first tackle the significance of using this tool and how it will aid financial statement users in their decision-making processes:

    Management may not be aware that collection problems are brewing, in case the trend in the aging of the receivables is on an upward swing. In some cases, the focus of management’s attention is only on the sales figures without considering that most of it only goes into the receivable accounts, and only a minimal amount of actual cash is realized at the time of sale. This can greatly affect the cash flow position and liquidity analysis, inasmuch as accounts receivables are supposed to be readily convertible into cash. It may also serve as a signal for management to review their policies in extending credit terms.

    Setting up an Allowance for Doubtful Accounts can serve as a constant monitoring, to readily estimate the amount of problem accounts as against those that are realizable in the near future.

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    Lenders in particular are interested in the accounts receivable balance, since this item in the balance sheet can serve as their quick gauge about the entity’s collection efficiency. A swift glance at a balance sheet that carries a substantial amount of receivables will prompt the analyst to examine the entity’s cash position. In addition, if the annual increase in receivables is near the amount of the annual income, it can be surmised that most of the revenue from sales are sold on credit terms, thereby limiting the amount of available cash.

    The bank’s credit analysts will look for a valuation reserve for the receivables account. The absence of the contra-asset account Allowance for Doubtful Accounts for large receivable balances can indicate that there is no proper monitoring.

    The Allowance for Doubtful Accounts will readily provide lenders information regarding how much the company is actually worth. In knowing the entity’s true and net realizable value, they can have a basis for deciding on the amount and type of loan to extend, the loan value of collateral, and the interest rate to impose, should they decide to take a risk and grant the loan being applied for.

    Investors on the other hand will want to gauge the company’s efficiency in utilizing the funds and if there are actual profits in store for them. Since lenders will have first priority over your assets, an Allowance for Doubtful Accounts will show the quality of assets they will have to contend with in case of liquidation.

    The IRS and the SEC will also be interested in the receivable accounts and its contra-asset provisions. The IRS will be alerted if the company suddenly claims a large expense for bad debts, if there was no valuation reserve set-up in the previous periods. They are wary of taxpayers who increase their expenses and downsize their income by using the valuation reserve account to balance their entries.

    The SEC on the other hand can readily analyze how much net realizable value is carried in the stockholders’ equity account. There have been cases of companies who were ordered to re-state their balance sheet accounts by recognizing the actual bad debts. This way, the SEC can protect the interest of prospecting investors by requiring companies to provide near-accurate information about their net realizable values. Like the IRS, the SEC is also wary of companies but for a different reason. The concern for the non-use of the Allowance for Doubtful accounts and its valuation reserve estimate is the company's bloated net worth.

    Please proceed to the next page for the Allowance for Doubtful Accounts - examples in estimating the amounts of valuation reserve.

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    Every financial user has his own reason in examining the Allowance for Doubtful Accounts. Examples provided all lead to a single objective--determining the net realizable value of the entity. Learn how to calculate the acceptable estimates in order to bring your Accounts Receivable component to its near-accurate balance.
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    Allowance for Doubtful Accounts: Examples of Estimating the Valuation Reserve

    There are several methods of estimating the amount to be assigned as Allowance for Doubtful Accounts, but under GAAP rules, the acceptable methods recognized in estimating for Allowance for Doubtful accounts are (1) based on the percentage of credit sales, and (2) based on the percentage of accounts receivables year-end balances.

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    Estimating the Allowance Based on Percentage of Credit Sales

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    In using this method, the matching of cost vs. income principle is the prevailing tenet, inasmuch as the valuation reserve is recognized as bad debt expense for the year.

    However, the entry will not affect the real account of the balance sheet since Allowance for Doubtful Accounts is only a contra-asset item that will affect only the balance sheet totals.

    To compute for the amount of valuation reserve, simply refer to the latest statistical trend in the business category’s past due trends on receivable accounts and then multiply the rate with the total credit sales for the year. As an example, let’s say the industry trend for the wholesale sector is 15.03%, and the company’s total credit sales for the year is $62,780. Simply multiply the two to get an estimate for the amount of valuation reserve, and you will get $9,435.

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    Estimating the Allowance Based on Percentage of Accounts Receivable Balance

    This method aims to report the year-end accounts receivable balance at its net realizable value. In using the same industry rate of 15.03% as example, we will compute an estimate for our valuation reserve by multiplying the rate to the balance of accounts receivable at year end, let’s say $15,000. The resulting product of $2,254 will be the amount assigned as Allowance for Doubtful Accounts upon recognition of post-adjusting entries at year end.

    It is important that management institutes a clear-cut policy on what method to use in calculating the estimated valuation reserve to ensure that the principle of consistency is maintained. In some instances, the industry rate for past due receivables may be considered as either too high or too low by management because it will not produce a near-accurate value of the accounts receivable.

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    Determining the Rate of Estimated Doubtful Accounts Based on Historical Trends

    The company may opt to base their estimate on historical data by reviewing their own trend of uncollected accounts during the past years. The rate is determined by computing the percentage of the actual uncollected receivables for the past two years (as example), over the base, which may be the total credit sales for the year or the year-end balance of the accounts receivable.

    To illustrate, supposing the actual uncollected accounts for 2007 was $1,600 and $2,450 for 2008, while the account receivables balances for the two year-ends are as follows: 2007- $12,800 and 2008- $16,400. To arrive at the estimated valuation reserve for the Allowance for Doubtful Accounts, examples and explanations are as follows:

    Actual Rates of Uncollected Accounts Receivable:

    2007= $1,600/ $12,800 x 100% = 12.5%

    2008 = $2,450 / $16,400 x 100% = 14.94%

    Average Annual Rate of Uncollected Accounts Receivable Based on Historical Figures:

    Ave. Rate = (12.5% + 14.54%) / 2 years

    Ave. Rate = 27.08% / 2 years

    Ave. Rate = 13.54%

    To compute for the current year’s Allowance for Doubtful Accounts, we will use this rate and the accounts receivable year-end balance in our previous example, $15,000. We will arrive at the amount of $2,031 as our valuation reserve for the year via the equation: $15,000 x 13.54%.

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    Accounting Entries for Allowance for Doubtful Accounts

    To complete our discussion about the Allowance for Doubtful Accounts, examples and explanations will make use of the accounting entries as the final steps in recognizing the bad debts of a company.

    (1) The following entry for recognizing the valuation reserve is usually taken up at year end as a post-adjusting entry:

    Dr. Bad Debts Expense __________ $2,031

    Cr. Allowance for Doubtful Accounts- Accounts Receivable __________$2,031

    (2) If a company’s policy postulates that for all past due accounts receivables with uncollected balances for two years, the customers have transferred their businesses elsewhere, it will be presumed they no longer have any intentions of settling their accounts. Hence the company policies for recognition of bad debts will include a provision that “all bad debts outstanding and uncollected for two years should be recognized to reduce the value of accounts receivable on the third year, in order to bring the said account to its near-accurate net realizable value." The following accounting entries will be included on the 2009 year-end post adjusting entry:

    Dr. Allowance for Doubtful Accounts-Accounts Receivable __________$1,600

    Cr. Accounts Receivable ____________ $1,600

    To recognize the actual uncollected accounts receivable for the year 2007 --- $1,600

    Note: You will notice that the figures used in downsizing the Accounts Receivable balance are the actual uncollected accounts and not the estimates, since the objective is to bring the receivable balance to its near accurate net realizable value.

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    Reference Material and Images Credit Section

    Reference Materials:

    • Accounting Coach. Allowance for doubtful accounts --- http://www.accountingcoach.com/terms/A/allowance-for-doubtful-accounts.html
    • Business Dictionary. Definition of valuation account --- http://www.businessdictionary.com/definition/valuation-account.html

    Images Credit from Wikimedia: