While collecting all the money you’re owed is the best-case scenario, small business owners know that things don’t always go as planned. Estimating invoices you won’t be able to collect will help you prepare more accurate financial statements and better understand important metrics like cash flow, working capital, and net income.
In particular, your allowance for doubtful accounts includes past-due invoices that your business does not expect to collect before the end of the accounting period. In other words, doubtful accounts, also known as bad debts, are an estimated percentage of accounts receivable that might never hit your bank account.
Let’s explore the importance of allowance for doubtful accounts, the methods of estimating it, and how to record it.
Methods for estimating allowance for doubtful accounts
The allowance for doubtful accounts, aka bad debt reserves, is recorded as a contra asset account under the accounts receivable account on a company’s balance sheet. It’s a contra asset because it’s either valued at zero or has a credit balance. In this context, the contra asset would be deducted from your accounts receivable assets and considered a write-off.
If you use the accrual basis of accounting, you will record doubtful accounts in the same accounting period as the original credit sale. This will help present a more realistic picture of the accounts receivable amounts you expect to collect versus what goes under the allowance for doubtful accounts.
There are five key methods for estimating the allowance. Let’s look at how to calculate allowance for doubtful accounts and how it can provide a more accurate picture of a company’s financial position:
Percentage of sales method
The percentage of sales method assigns a flat rate to each accounting period’s total sales. Using previous invoicing data, your accounting team will estimate what percentage of credit sales will be uncollectible.
For example, a jewelry store earns $100,000 in net sales, but they estimate that 4% of the invoices will be uncollectible. The company’s allowance for doubtful accounts is $4,000.
Accounts receivable aging method
The accounts receivable aging method uses accounts receivable aging reports to keep track of past due invoices. Using historical data from an aging schedule can help you predict whether or not you’ll receive an invoice payment.
For example, our jewelry store assumes 25% of invoices that are 90 days past due are considered uncollectible. They assume that 75% of the invoices in this age group will be paid. Say it has $10,000 in unpaid invoices that are 90 days past due—its allowance for doubtful accounts for those invoices would be $2,500, or $10,000 x 25%.
The risk classification method involves assigning a risk score or risk category to each customer based on criteria—such as payment history, credit score, and industry. The company then uses the historical percentage of uncollectible accounts for each risk category to estimate the allowance for doubtful accounts.
To use the risk classification method:
- Assign a risk score or category to each customer.
- Determine the historical percentage of uncollectible accounts for each category.
- Multiply the accounts receivable amount for each category by the historical percentage.
- Add up the estimated allowances for each category.
For example, our jewelry store may assign a customer a risk category of C. That category has a historical percentage of uncollectible accounts of 10%. The customer has $5,000 in unpaid invoices, so its allowance for doubtful accounts is $500, or $5,000 x 10%.
Pareto analysis method
The Pareto analysis method relies on the Pareto principle, which states that 20% of the customers cause 80% of the payment problems. By analyzing each customer’s payment history, businesses allocate an appropriate risk score—categorizing each customer into a high-risk or low-risk group. Once the categorization is complete, businesses can estimate each group’s historical bad debt percentage.
For example, our jewelry store has 1,000 customers:
- We determine 200 customers are high-risk and 800 are low-risk.
- The historical bad debt percentage for the high-risk group is 5% and 1% for the low-risk group.
- The outstanding balance for the high-risk group is $500,000, and $1,500,000 for the low-risk group.
As a result, the estimated allowance for doubtful accounts for the high-risk group is $25,000 ($500,000 x 5%), while it’s $15,000 ($1,500,000 x 1%) for the low-risk group. Thus, the total allowance for doubtful accounts is $40,000 ($25,000 + $15,000).
Specific identification method
The specific identification method allows a company to pick specific customers that it expects not to pay. In this case, our jewelry store would use its judgment to assess which accounts might go uncollected.
For example, it has 100 customers, but after assessing its aging report decides that 10 will go uncollected. The balance for those accounts is $4,000, which it records as an allowance for doubtful accounts on the balance sheet.
How do you record allowance for doubtful accounts
When a business makes credit sales, there’s a chance that some of its customers won’t pay their bills—resulting in uncollectible debts. To account for this possibility, businesses create an allowance for doubtful accounts, which serves as a reserve to cover potential losses.
Creating this allowance ensures that the financial statements reflect a more accurate picture of the company’s financial position and performance. The allowance provides a cushion against potential losses arising from bad debts, which may otherwise significantly impact the company’s cash flow and profitability. When recording an allowance for doubtful accounts, here are the four steps to follow:
1. Create allowance for doubtful accounts
Companies create an allowance for doubtful accounts to recognize the possibility of uncollectible debts and to comply with the matching principle of accounting. After figuring out which method you’ll use, you can create the account in the chart of accounts.
The accounting journal entry to create the allowance for doubtful accounts involves debiting the bad debt expense account and crediting the allowance for doubtful accounts account.
2. Adjust allowance for doubtful accounts
After creating an allowance for doubtful accounts, it is important for companies to regularly review and adjust this account to ensure that it accurately reflects the current state of their working capital and accounts receivable.
The adjustment process involves analyzing the current accounts, assessing their collectibility, and updating the allowance accordingly.
The adjustment process often involves two steps:
- An evaluation of the accounts: This step involves looking at all the accounts receivable, assessing the collectibility of each account, and determining the amount of allowance necessary to cover the estimated bad debts.
- An adjustment of the allowance: The next step involves updating the allowance account—either upward or downward—to reflect the estimated uncollectible amount.
Adjusting the allowance for doubtful accounts is important in maintaining accurate financial statements and assessing financial risk.
3. Write off an account
When assessing accounts receivable, there may come a time when it becomes clear that one or more accounts are simply not going to be paid. In these cases, the best course of action is often to write off the account.
Writing off an account means removing it from the accounts receivable balance, as it is no longer considered an asset of the company. The allowance for doubtful accounts journal entry for this is to:
- Debit allowance for doubtful accounts
- Credit accounts receivable
Remember that writing off an account does not necessarily mean giving up on receiving payment. In some cases, the company may still pursue collection through a collection agency, legal action, or other means.
4. Recover an account
Recovering an account means collecting a debt that has been previously written off or deemed uncollectible. If you recover money, you’ll want to make a journal entry adjusting your books to account for the recovery. The journal entry is:
- Debit accounts receivable or cash account
- Credit bad debt expense
Recovering an account may involve working with the debtor directly, working with a collection agency, or pursuing legal action.
Allowance for doubtful accounts benchmarks
Ideally, you’d want 100% of your invoices paid, but unfortunately, it doesn’t always work out that way. Assuming some of your customer credit balances will go unpaid, how do you determine what is a reasonable allowance for doubtful accounts? It depends on your business, customers, and industry.
Let’s examine some key benchmarks for the allowance for doubtful accounts. This table highlights standards for accounts receivable and days sales outstanding (DSO) for key industries, as collected by Dun & Bradstreet:
This article originally appeared on the QuickBooks Resource Center and was syndicated by MediaFeed.org.
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6 ways to stop getting hit with this very avoidable fee
A minimum balance fee is a fee that many banks charge when your account balance dips below a certain dollar amount. For example, if the minimum balance required in your checking account is $500, but you only have $450, you would be charged a minimum balance fee.
These fees are often presented as account maintenance charges, with exceptions for account holders who maintain a monthly minimum balance in their account. Typically, the major national banks require you to maintain a minimum balance of around $300 to $500, although it can be more, to avoid monthly service fees.
There are different types of minimum balance requirements. A bank may define a minimum balance in one of these three ways:
- Minimum balance This typically means your account balance cannot drop below the specified amount at any time during your statement cycle or you will be charged a fee.
- Minimum daily balance Often used for checking accounts, this means your balance can drop below the required amount at any point during the day as long as you meet the balance requirement at the end of the business day.
- Average minimum balance Here, the bank takes the amount of money in your account at the end of each day during a statement period and divides it by the number of days during the statement period. If your average balance was below the minimum, you would get hit with a maintenance fee.
How Much Is a Typical Minimum Balance Fee?
A recent Bankrate study found that, on average, financial institutions are charging $5.31 per month in maintenance fees for non-interest-bearing checking accounts and $15.33 for interest checking accounts. That adds up to roughly $64 and $184, respectively, per year. Keep in mind, though, that this is just the average — minimum balance fees can be even higher at some banks.
Minimum balance fees are typically automatically deducted from your account.
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There are a number of ways to avoid getting hit with a minimum balance fee. Here are some to consider.
1. Keeping Your Account Above the Minimum Balance
Perhaps the most obvious way to avoid a minimum balance fee is to keep your account balance above the stated minimum amount. However, this might take some effort on your part.
First, you’ll need to read the fine print in your account information, or call your bank, to find out what the minimum balance is and — equally important — how it’s calculated. In some cases, you may be penalized for having your balance dip below the minimum at any point. In others, the bank will look at the balance at the end of each day or average your daily balances for the statement period.
If it’s an account you pull from frequently (like a checking account), you’ll need to pay close attention to your balance to avoid fees. You might want to set up an alert for any time you account dips below a certain amount.
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Another possible strategy is to link multiple accounts you have at the same bank. In some cases, banks will look at your combined account balance (such as your checking and your savings account balance) to determine if you’ll owe a service or maintenance fee. This may or may not be an option where you bank, so again, you’ll want to look into the details of your account.
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You may be able to avoid minimum balance fees by signing up for direct deposit. This allows your employer to send your pay straight to your bank account, so you won’t need to deposit a paper check each payday. While the main benefit of direct deposit is the convenience, many banks provide added incentives to account holders who are paid this way, including monthly fee waivers.
Some banks will require you to receive a certain amount of money in direct deposits each month to dodge monthly fees. If so, you won’t want to distribute your income to more than one account. Rather than split your direct deposit between checking and savings, for example, you might have it all go to checking and then transfer some of that money into savings each month.
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Some banks will waive monthly maintenance fees for account holders who use a debit card linked to the account a certain number of times each month, often around 10 transactions. The reason is that whenever you swipe your debit card, the merchant pays your bank a transaction fee; these fees can make up for the loss of your monthly account fee.
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Some banks will waive monthly fees as long as you opt into e-statements. This means that instead of getting a paper statement in the mail every month, you’ll simply access it by logging into your account online (where you can view, download, or print your statements) or via your bank’s mobile app.
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One surefire way to get rid of minimum balance fees is to switch to a bank that doesn’t charge them. Online banks generally charge fewer fees because without brick-and-mortar branches to maintain, they have less overhead. In addition, they tend to offer higher annual percentage yields (APY), which makes it even easier to save each month.
If you’re in school, keep in mind that a number of banks offer no-fee checking accounts to college students. To open a student account, you typically need proof of student status (such as a college ID, an admittance letter, or a transcript).
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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SoFi members with direct deposit activity can earn 4.50% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a deposit to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate.
SoFi members with Qualifying Deposits can earn 4.50% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant.
SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.50% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.
SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.
Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.
Interest rates are variable and subject to change at any time. These rates are current as of 8/9/2023. There is no minimum balance requirement. Additional information can be found at SoFi.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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