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Allowance for Doubtful Accounts: Statement of Financial Position/Balance Sheet

It is rare for an entity to be able to collect all of their Accounts Receivable (A/R). This means that in order to present an accurate assessment of A/R, we need to determine how many A/R are not receivable in full. Remember that Accounts Receivable must be measured at Net Realizable Value, which means that we need some way of determining how much will never be paid, and netting this amount from our Accounts Receivable balance.

But before we dive into the different approaches for determining the Net Realizable Value, let’s take a step back and understand why we need all of this in the first place.

  • As part of our basic assumptions, we are assuming that we are using accrual accounting.

  • In accrual accounting, we recognize Revenue when it is earned, and not necessarily when it is paid.

  • This means that there will be times when we are recognizing Revenues in some years, despite that they might never be paid.

  • This also means that we need some way of accounting for uncollectible amounts so that they are ultimately netted off of the Revenue figure. Remember that we should not be overstating our net income and misleading financial statement users, so we absolutely need to account for Revenue which might never be collected upon.

  • Since we cannot net uncollectible amounts directly off of Revenue (we discussed this in an earlier post), the only other way to reduce our net income amounts would be to create an Expense.

  • An amount that will never be collected is considered a Bad Debts Expense. This will be netted from Revenue on the Income Statement, when arriving at the profit/loss (net income) figure.

  • This Bad Debts Expense account will be shown separately, under Operating Expenses on the Income Statement.

  • Note also that in the process of creating this Revenue figure, we will have also recorded an Accounts Receivable. Revenue belongs on the Income Statement, and Accounts Receivable belong on the Balance Sheet/Statement of Financial Position. We cannot be overstating either the Income Statement or the Balance Sheet/Statement of Financial Position.

  • Which means that we also need to somehow reduce our Accounts Receivable balance, in order to show only the amount that is expected to be realized (a.k.a. Net Realizable Value)

  • For this, we have a contra-asset account called Allowance for Doubtful Accounts.

Below is a visual representation of the different elements and how they balance each other out:

Income Statement:

Statement of Financial Position/Balance Sheet

Unlike the rest of the accounts, the Allowance for Doubtful Accounts (AFDA) is not something that shows up on the financial statements. This is because it is a contra-asset account, which is netted from the Accounts Receivable balance. It is simply a placeholder account that the entity uses to keep track of their doubtful accounts. When preparing the year-end financial statements, the contra-asset account is netted from the A/R account, resulting in an A/R figure net of discounts.

Measuring Net Realizable Value for A/R

There are two approaches to measuring and recognizing the uncollectible amounts. The entity should first use historical data along with information about the current status of the debtors (i.e. customers) to evaluate their ability to pay. For example, if a customer has gone bankrupt, we might determine that there is a very low (or no) possibility that they will ever be able to pay what they owe. Once the entity has determined potential uncollectible amounts and reviewed historical trends, then there are two broad types of approaches available to recognize this amount in the entity’s books.

Direct Write-off Method:

The first approach is the Direct Write-Off Method. With this method no provision is made, and the uncollectible amount is written off directly as an expense. Note that we will only make this journal entry once we have deemed the amount uncollectible.

While this is considered one of the approaches available to users using certain accounting frameworks (e.g. entities using ASPE), it is not an appropriate approach under IFRS. The reason this is not an appropriate approach is because there may be timing differences between when the Revenue is recognized and when the Bad Debts Expense is recognized. For example, we might not know (with sufficient certainty) whether or not an amount is uncollectible until a few months after we have recognized the Revenue, or even until the next fiscal year. This means that we may not be adhering to the matching principle, where we should try to match the Expense with the associated Revenue within the same time period.

Provision / Allowance for Doubtful Accounts (AFDA) Method:

This method allows us to make an estimate, throughout the year, while our Revenue is being recognized and our A/R balances are accumulating. We can make these estimates even if we do not yet know which accounts will not be paid. This method paints a more accurate picture for our financial statement users because it shows A/R at its estimated Net Realizable Value throughout the year - and not just when we are certain an amount should be written off.

To do this, we create a provision account called the Allowance for Doubtful Accounts (AFDA). AFDA is a contra-asset account. This means that it is netted from the A/R account when the financial statements are prepared. Within this method, there are two acceptable approaches which can be used:

Balance Sheet Approach (aka “aging method”):

This approach uses a % of A/R balance as an estimate for the AFDA provision. Steps are as follows:

Step 1: Write off specific accounts that you know are uncollectible.

Step 2: Of the remaining A/R, take a % of A/R balance as the appropriate AFDA. This is usually an estimate based on historical data.

Step 3: Increase/Decrease the Bad Debt Expense to this amount.



IMPORTANT: We do not directly calculate the Bad Debt Expense. It is the residual amount necessary to achieve the desired AFDA balance.

One way to determine the AFDA and Bad Debt Expense is to use T-Accounts first, then do the journal entries afterwards. This also simplifies adjusting year-over-year, where it can be difficult to keep track of allowances.

Here is an example template using the T-Account approach:

Associated journal entry:

"W" is also referred to as the “Total Allowance Required”.

Income Statement Approach (aka “credit sales method”):

This approach uses a % of Credit Sales (or total Sales) balance as an estimate for the AFDA provision. Steps are as follows:

Step 1: Write off specific accounts that you know are uncollectible.

Step 2: Bad Debt Expense is Calculated based on % Credit Sales (or total Sales).

IMPORTANT: We do not calculate the AFDA directly -> it results from the calculation of Bad Debt Expense. AFDA is, therefore, increased by the Bad Debt, amount regardless of any opening balance.

Here is an example template using the T-Account approach:

Associated journal entry:

TIP: If a case states that the provision is calculated using % A/R, then we know to use the Balance Sheet approach (because A/R is shown on the B/S), and if the case states the provision is calculated using the % Credit Sales, then we know to use the Income Statement Approach (since Sales Revenues is shown on the Income Statement).

Customer Pays Back Something that was Written Off:

When a customer pays a debt that had previously been written off, then we need to make an adjusting journal entry.

The same entry is made, under both Balance Sheet and Income Statement approaches.

Decrease your AFDA and increase your A/R.

Record the Cash obtained, and decrease your A/R

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