A doubtful account or doubtful debt is an account receivable that might become a bad debt at some point in the future. If customers purchase on credit, establishing an allowance of doubtful accounts is an important tool for your balance sheet and income statement.
Your accounts receivables team may not know which specific will go unpaid, but with a historical record and good forecasting, they can anticipate approximately how much potential revenue will become bad debt.
Why track doubtful accounts?
Doubtful accounts can turn into bad debt, and bad debt impacts your business’ bottom line. The ability to accurately forecast and account for bad debt means you have better insight into your working capital - and the health of your business.
To account for the doubtful debt (or doubtful accounts), you create an allowance, which is recorded on your balance sheet. The balance sheet presents your company’s assets, liabilities, and equity. An allowance for doubtful accounts reduces your reported amount of accounts receivables.
An allowance for doubtful accounts is established in a reserve account (also known as a contra account) that reduces your accounts receivables, so it is recorded under assets, as a reduction after the accounts receivables line. Estimate the amount of accounts receivables that may become bad debts over a given period of time, and enter a credit of that amount in your reserve account: this is your allowance of doubtful accounts.
In simple terms, in your double-entry books, debit your bad debts expense account and credit your allowance of doubtful accounts. When there is a bad debt, debit your allowance of doubtful accounts and credit your accounts receivable account.
For example: Company XYZ has $200,000 of accounts receivable, of which it estimates that $10,000 will eventually become bad debts. It therefore charges $10,000 to the bad debt expense (which appears in the income statement) and a credit to the allowance for doubtful accounts (which appears just below the accounts receivable line in the balance sheet). A month later, XYZ knows that a $2,000 invoice is indeed a bad debt. It creates a credit memo for $2,000, which reduces the accounts receivable account by $2,000 and the allowance for doubtful accounts by $2,000.
So, when XYZ recognizes the actual bad debt, there is no impact on the income statement - only a reduction of the accounts receivable and allowance for doubtful accounts line items in the balance sheet, and those offset each other.
Doubtful account versus bad debt
A bad debt is an account receivable that has been clearly identified as not being collectible, and should be written off at once. A doubtful debt is an account receivable that might become a bad debt but it’s not certain if or when that will happen
How to estimate your doubtful accounts
One common way to estimate how much your allowance for doubtful accounts should be is to rely on historical data. If your business was steady in the year prior and you do not anticipate significant changes to your business in the upcoming months, this is a simple and fast way to look at it.
Another method is to use your aging receivables. In this method you would group your aging receivables and determine the percentage for each group that is likely to become uncollectible.
For example, for invoices that are 31-60 days past due, you might determine that 10% of them are likely to become uncollectible. In this grouping, you have invoices total $10,000. So you would take 10% of $10,000, for $1,000 to be assigned to your doubtful account allowance.
Invoices that are 61-90 days past due might be assigned 15% uncollectible, and if you have $7.500 outstanding in this grouping, then $1,125 would be reserved for your allowance of doubtful accounts.
This brings your total for those two groups to a doubtful account allowances of $2,125.
The allowance for doubtful accounts helps report the bad debt expense as soon as the estimate is calculated and portrays a more accurate view of the financial statements. Tracking those doubtful accounts also gives you insight into your customer base, and which segments may be higher risk for you - therefore altering your target market or credit management processes to ensure your business is protected. For both financial compliance and business health reasons, managing your doubtful accounts is important in your business.