Allowance for doubtful accounts is a contra account that adjusts accounts receivable for the expected amount of uncollectible accounts.
The allowance for doubtful accounts contra account is associated with the allowance method, which is one of two ways for accounting for uncollectible receivables. The other method is the direct write-off method, in which bad accounts are directly expensed.
Under the allowance method, the firm estimates the amount of uncollectible receivables associated with that period’s credit sales. The firm recognizes an increase in allowance for doubtful accounts with a corresponding entry to bad debt expense. When the firm actually deems an account to be uncollectible, the firm recognizes the bad debt against allowance for doubtful accounts.
For example, suppose XYZ Supply, Inc. sells $100,000 worth of plumbing supplies on account in the month of June. Based on historical experience, XYZ estimates that 2% of the credit sales will go unpaid. So, at the end of June, XYZ makes the following journal entry: debit bad debt expense for $2,000 and credit allowance for doubtful accounts for $2,000.
Suppose in July the firm deems a $1,000 account uncollectible. Under the allowance method, the write-off involves debiting allowance for doubtful accounts for $1,000 and crediting accounts receivable by $1,000.
Sometimes firms will receive all or partial payment on a previously recognized uncollectible debt. When this occurs under the allowance method, the firm must make two different accounting entries. First, the firm debits accounts receivable and credits allowance for doubtful accounts by the amount of the payment. Second, the firm debits cash and credits accounts receivable.
