Doubtful account

Doubtful accounts are used to present the estimated amount of accounts receivable that is expected to become uncollectible in the future. Assessment of the allowance for doubtful accounts has a direct impact on income, and therefore proves to be of high importance for companies which use the reserve method for bad debts accounting.

Historical background

The need for estimating doubtful accounts allowance is connected with the commercial lending development. Low availability of cash assets made the companies ship their products without upfront payment in order to increase revenues. As a consequence, bad debts started to occur. Bankers were the first who came up with the idea of measuring the allowance for doubtful debts. The concept started by Florentine Bank Medici was subsequently adopted by other countries.

Estimating the allowance for bad debts

According to international financial reporting standards, accounts receivables should be considered a financial asset and therefore they should be subject to impairment tests resulting in a comparison of the asset's carrying value and its probable recoverable amount. The allowance deducts the asset's carrying amount to its likely recoverable amount. Organizations are obligated to show the bad debts allowance if the impairment test proves that allowance is material.

Doubtful accounts allowance should be assessed based on operational data as well as the following factors:

• possibility that the debt is recoverable,
• past debts repayment dates,
• probability of repayment based on the client data.

Evaluation of the estimation process

Estimating bad debt allowance is a process which requires making a decision based on multiple factors. Audit of the estimated values is difficult. Some of the audit techniques use historical trend analysis to measure estimation accuracy. Three of them are described below:

1. Comparing write-offs to bad debt expense. If a bad debt expense occurred during the year, it is necessary to proceed with a write-off within that year and subsequent ones. Estimated bad debt is not likely to match the write-off exactly, however, the ratio of these two is expected to be close to 1.0. Significantly lower ratios for multiple years may imply underestimating the impact of doubtful accounts. Substantially higher ratios may suggest that excessive allowance might have been accumulated.
2. Comparing write-offs to beginning allowance. The ratio of beginning allowance for doubtful accounts to write-offs is calculated yearly using the allowance at the beginning of the year as the numerator and accounts receivable write-offs as the denominator. This ratio is also called the beginning-allowance-to-write-offs ratio. It shows how accurately the write-offs are absorbed by the allowance. If the allowance at the beginning of the year was not high enough to accommodate approaching write-offs, the ratio is expected to be rather low. On the other hand, high ratios might imply that excessive allowance might have been accumulated by the entity.
3. Calculating the exhaustion rate of the allowance. Exhaustion rates express the number of years that was needed to write off the allowance amount from the beginning of the year.

Examples of Doubtful account

• Fraudulent Payments: A fraudulent payment is a payment made to an individual or entity that was not legally owed to them. For example, if a company overpays a vendor by accident, the vendor has no legal right to keep the money and must return it. However, if the vendor refuses to return the money, the company may need to write off the payment as a doubtful account.
• Outstanding Invoices: Unpaid invoices are one of the most common types of doubtful accounts. This occurs when a customer fails to pay an invoice for goods or services rendered. After a certain period of time, the amount due on the invoice may be written off as a doubtful account.
• Bankruptcy: Companies that file for bankruptcy are not always able to pay off their debts. As a result, creditors may have to write off any outstanding debts as a doubtful account.
• Non-Collectible Accounts: In some cases, a customer may be unable to pay an invoice due to financial hardship. This may be due to unemployment, medical bills, or other reasons. In these cases, the invoice may be written off as a non-collectible account.
• Unpaid Taxes: Government agencies may have the power to collect unpaid taxes from individuals or businesses. If the taxes remain unpaid for a certain period of time, the amount may be written off as a doubtful account.

Advantages of Doubtful account

Here are several advantages of having a doubtful account:

• It provides a more accurate picture of a company’s financial position. By having a doubtful account, it can help identify accounts receivable that are in danger of becoming bad debts, so that the company can take proactive steps to minimize the potential loss.
• It also helps to better assess the real value of the company's assets and liabilities. When doubtful accounts are included, the true value of the assets and liabilities can be determined more accurately.
• It helps to improve the creditworthiness of the company. By having a doubtful account, it can reduce the company's risk of defaulting on its debt obligations. This can lead to better terms from creditors in the future.
• It can also help to protect the company's reputation. By having a doubtful account, it can show creditors and other stakeholders that the company is taking steps to mitigate its risk of default. This can help to maintain the company's good standing in the business community.

Limitations of Doubtful account

One of the limitations of the Doubtful account is that it can be difficult to estimate the exact amount of money that a customer owes. Here are some further limitations of the Doubtful account:

• An accountant must make an estimate based on the customer’s financial background, and this estimate may be inaccurate.
• There may be disagreements between the accountant and customer about the amount owed.
• It can be difficult to keep track of the amounts owed, as customers may have multiple accounts with different payment terms and due dates.
• The accountant may need to factor in the customer’s ability to pay and the likelihood of payment.
• It may require additional resources to track the amount and the customer’s account status.
• The amount owed may change over time, depending on the customer’s payment habits.

Other approaches related to Doubtful account

In addition to the Doubtful Accounts approach, there are other approaches to dealing with accounts receivable that are past due or are unlikely to be paid, such as:

• Allowance for Doubtful Accounts: This approach is similar to the Doubtful Accounts approach, but instead of a direct write-off, the company estimates the amount of receivables that will likely not be collected, and creates an allowance for that amount.
• Bad Debt Reserve: This approach involves setting aside an amount of money to cover potential losses due to customers not paying their accounts.
• Credit Insurance: This type of insurance covers some or all of the company’s accounts receivable, in the event that customers fail to pay.
• Collection Agencies: Companies can hire collection agencies to help collect past due accounts, which can be more effective than trying to collect on their own.

Overall, there are various approaches to dealing with accounts receivable that are past due or are unlikely to be paid, such as Allowance for Doubtful Accounts, Bad Debt Reserve, Credit Insurance, and Collection Agencies.

Footnotes

Doubtful account — recommended articles

Accounts uncollectible — Credit Review — Prepaid income — Beacon Score — Bad debt recovery — Closing entry — Bank reference — Aging schedule — Trade receivables

References

• Cyert, R. M., Davidson, H. J., Thompson, G. L. (1962),Estimation of the allowance for doubtful accounts by Markov chains, "Management Science", Vol 8 Issue 3.
• Finger C. A. (2010), Using judgment to measure the allowance for doubtful accounts, "Global Perspectives on Accounting Education", Vol 7.
• Kulikova L. I., Garyncev A. G., Goshunova A. V. (2015), Doubtful Debts Allowance Development: Stages and Methods of Calculation, '"Mediterranean Journal of Social Sciences", Vol 6 No 1 S 3.
• Riley M. E., Pasewark W. R. (2009), Assessing the Allowance for Doubtful Accounts,"Journal of Accountancy", Vol 208 Issue 3.

Author: Magdalena Wojslaw