How Allowance for Doubtful Accounts Is Shown on the Balance Sheet

The allowance for doubtful accounts represents a contra-asset account that reduces accounts receivable to its realizable value. It reflects management’s estimate of the portion of receivables that may not be collected due to customer defaults, disputes, or credit deterioration. Recognizing this allowance ensures that the balance sheet presents a realistic view of expected cash inflows and aligns with the principle of prudence in financial reporting.

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How the allowance for doubtful accounts arises

When a company extends credit to customers, there is always a risk that some will fail to pay. To anticipate these potential losses, companies establish an allowance for doubtful accounts at the end of each reporting period. The allowance is based on historical collection experience, current customer credit quality, and forward-looking information under IFRS 9 or ASC 326 (CECL model).

Example:If total accounts receivable amount to 500,000 and management estimates that 4 percent will be uncollectible, the allowance for doubtful accounts is 20,000. Net realizable value is therefore 480,000.

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Presentation on the balance sheet

The allowance for doubtful accounts is deducted directly from accounts receivable to show the expected collectible amount.

Example:

• Accounts Receivable: 500,000

• Less: Allowance for Doubtful Accounts: (20,000)

• Net Accounts Receivable: 480,000

This presentation highlights that the asset balance represents an estimate of what the company expects to collect, not the contractual amount owed.

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Journal entries for the allowance and write-offs

To establish or adjust the allowance:

• Debit: Bad Debt Expense 20,000

• Credit: Allowance for Doubtful Accounts 20,000

When a specific receivable is written off:

• Debit: Allowance for Doubtful Accounts 5,000

• Credit: Accounts Receivable 5,000

If a previously written-off account is recovered:

• Debit: Accounts Receivable 5,000

• Credit: Allowance for Doubtful Accounts 5,000

• Debit: Cash 5,000

• Credit: Accounts Receivable 5,000

These entries maintain accurate reporting of expected credit losses.

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Standards under IFRS and US GAAP

• IFRS 9 (Financial Instruments): Requires recognition of expected credit losses (ECL) using a forward-looking model, considering historical data, current conditions, and future economic forecasts.

• US GAAP (ASC 326, Current Expected Credit Loss – CECL): Similar forward-looking approach, requiring recognition of lifetime expected losses at initial recognition.

Both frameworks replaced the incurred loss model with one emphasizing early recognition of potential credit deterioration.

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Impact on financial performance and ratios

The allowance for doubtful accounts affects both the balance sheet and income statement. The increase in allowance raises bad debt expense, reducing net income for the period. On the balance sheet, it lowers the value of receivables and current assets, which can affect liquidity ratios.

For example, if current assets before adjustment total 600,000 and the allowance increases by 20,000, the current ratio will decrease slightly, signaling a more conservative but accurate liquidity position.

Analysts view a well-maintained allowance as a sign of prudent credit management, while sudden spikes may indicate deteriorating customer quality or changes in collection policy.

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Disclosures required for the allowance for doubtful accounts

Companies must disclose:

• The basis for estimating uncollectible accounts.

• Movements in the allowance account during the period.

• Write-offs and recoveries.

• Key assumptions about customer credit risk and macroeconomic factors.

Such transparency allows investors to evaluate the quality of a company’s receivables and the robustness of its credit risk management practices.

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Operational considerations

The allowance for doubtful accounts is not merely an accounting estimate—it reflects a company’s discipline in managing customer relationships and credit exposure. Firms that regularly analyze aging schedules, monitor collection trends, and adjust allowances dynamically are better equipped to avoid earnings volatility. For investors and creditors, consistent and well-supported allowances indicate sound governance and risk awareness in revenue realization and working capital management.

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