Allowance for doubtful accounts (ADA) is a financial metric that estimates the value of rendered services or goods sold that you don’t expect to get paid for. Essentially, it’s a tool used in accrual accounting as a way of tracking bad debt up front with the end goal of maintaining more accurate financial statements.
But what is the allowance for doubtful accounts in application and how do companies calculate it?
Why Track Allowance for Doubtful Accounts?
Tracking ADA helps you maintain more accurate balance sheets. ADA is a type of contra asset account used to reduce your account receivable balance (“contra asset” referring to an asset account where the account balance is a credit balance). ADA is paired with bad debt expenses on your company’s balance sheet, meaning that when you fail to collect on an invoice, ADA is credited and bad debt expense is debited.
This is important due to one common and unfortunate business reality: Companies don’t always pay what they owe. When a company fails to pay some or all of its debt, that sum should be accounted for in the balance sheet to create the most accurate snapshot possible of accounts receivable (A/R) and financial health overall.
The allowance for doubtful accounts helps CFOs and controllers better understand the true state of a company’s finances and make more accurate cash flow projects long-term via balance sheet forecasting. It can also be thought of as a risk assessment tool that gives finance teams a better idea of how future clients may perform with respect to paying their debts.
How to Calculate Allowance for Doubtful Accounts
There are three primary ways to create an estimation of doubtful accounts.
Percent of Credit Sales / A/R
The first method involves examining credit sales (or the percentage of total collected A/R) and using historical collection data to determine how much of your invoices are written off, on average.
For example, if your company assesses A/R with a total value of $10,000,000 and your historical default rate is 2%, you can assume that $200,000 of your total will fall under doubtful accounts receivable. This method is simple and works best for companies with straightforward billing cycles that operate primarily on credit.
Accounts Receivable Aging Report
The second method uses A/R aging reports to assign expected default rates to aging categories. The longer a given account remains in delinquency, the more likely it is that it’ll fall into doubtful accounts receivable. Here’s an example of how this might look:
With this data, your ADA calculation would be this:
Then, subtract your ADA from your total A/R:
Customer Risk Classification
The third method takes the most granular approach yet by assigning personalized default risk percentages to each customer based on historical trends. This method is commonly used when client relationships span years and provide plenty of historical data for your business to pull from.
Given that the default probability is unique to each company, this method offers the most accurate way of predicting ADA. However, it’s dependent on maintaining a small, consistent customer base that can be measured, with calculation efforts increasing as your client base grows. Typically, larger businesses rely on one of the first two methods due to the complexity of running these assessments across a big customer pool.
Managing Accounts Receivable and Allowance for Doubtful Accounts
While no company expects to see substantial amounts of value lost through bad debt, it’s an important metric to stay on top of. Fortunately, ADA is relatively straightforward to track with the above methods. (No particular method is truly better than another; what works for one business may be unsuitable for another.)
Regardless of how you choose to measure it, ADA calculations can be easily set up and managed through solutions that automate the collection process. Even with larger customer pools, companies can run these reports as often as needed to ensure they’re maintaining an accurate view of their finances.
For more information on these calculations and assistance setting up a better reporting system, contact Gaviti! Our automated A/R software makes it easy to track financial metrics and stay on top of every calculation your business needs to be productive. Visit our website and we’ll show you how.