What if a company’s Allowance for Doubtful Accounts is understated?

the allowance for doubtful accounts is a contra asset account that equals

Allowance for Doubtful Accounts pairs with the Bad Debts Expense account when doing adjusting journal entries. Accumulated Depreciation is a contra asset that pairs with Fixed Assets. Accumulated Depreciation acts as a subaccount for tracking the ongoing depreciation of an asset. Each year of an asset’s life, another year of Depreciation Expense is recorded.

  • Or, the company may have to find other sources of cash to pay its debts within the discount period.
  • The Pareto analysis method relies on the Pareto principle, which states that 20% of the customers cause 80% of the payment problems.
  • The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the desired credit balance (the target) in the Allowance for Uncollectible Accounts.
  • As of January 1, 2018, GAAP requires a change in how health-care entities record bad debt expense.
  • A company uses this account to record how many accounts receivable it thinks will be lost.
  • Hence, the book value of the liability will be the credit balance of the liability account minus the debit balance of its contra liability counterpart.
  • This account serves two purposes — tracking total depreciation expenses while providing you with the accurate book value of the asset being depreciated.

If a contra account is not used, it can be difficult to determine historical costs, which can make tax preparation more difficult and time-consuming. So far, we have used one uncollectibility rate for all accounts receivable, regardless of their age. However, some companies use a different percentage for each age category of accounts receivable. When accountants decide to use a different rate for each age category of receivables, they prepare an aging schedule. An aging schedule classifies accounts receivable according to how long they have been outstanding and uses a different uncollectibility percentage rate for each age category.

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The allowance for doubtful accounts also helps companies more accurately estimate the actual value of their account receivables. A contra liability is an account in which activity is recorded as a debit balance is used to decrease the balance of a liability. Contra Liability a/c is not used as frequently as contra asset accounts. It is not classified as a liability since it does not represent a future obligation.

All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Go a level deeper with us and investigate the potential impacts of climate change on investments like your retirement account. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Assign a risk score to each customer, and assume a higher risk of default for those having a higher risk score.

An example of recording a contra asset

Therefore, for these three, the debit balance actually represents a negative amount. The Allowance account’s credit balance is presented with or combined with the debit balance in the Accounts Receivable so that the balance sheet reports the net amount that is expected to be collected. Classifying accounts receivable according to age often gives the company a better basis for estimating the total amount of uncollectible accounts. For example, based on experience, a company can expect only 1% of the accounts not yet due (sales made less than 30 days before the end of the accounting period) to be uncollectible. At the other extreme, a company can expect 50% of all accounts over 90 days past due to be uncollectible. For each age category, the firm multiplies the accounts receivable by the percentage estimated as uncollectible to find the estimated amount uncollectible.

For example, if the balance of accumulated depreciation increases from $20,000 to $50,000, this means that the depreciation expense amounts to $30,000, which will be listed in the income statement. With accounting software like QuickBooks, you can access important insights, including your allowance for doubtful accounts. With such data, you can plan for your business’s future, keep track of paid and unpaid customer invoices, and even automate friendly payment reminders when needed. 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.

Why are contra asset accounts important for businesses?

Unlike the three previously mentioned contra accounts, contra revenue accounts are not listed in the balance sheet but are written near the top of the income statement. Contra revenue Running Law Firm Bookkeeping: Consider the Industry Specifics in the Detailed Guide accounts typically offset revenue accounts in a firm’s income statement. Of that amount, it is estimated that 1% of that amount will become bad debt at some point in the future.