Allowance for doubtful accounts is an overall depletion of a total number of accounts receivable that appear on the balance sheet of a particular company. Such an instrument helps estimate the approximate amount of the accounts receivable, which will not be paid by the customer. Thus, allowance for doubtful accounts is a valuable tool for financial flow controlling.
Explanation:
An allowance for doubtful accounts is one of the basic constituents of a balance sheet. The balance sheet serves as a layout of all the business’ accounts and as an indicator of the financial performance of a company.
In the context of a balance sheet, allowance for doubtful accounts estimates what accounts receivable need to be reduced or eradicated from the document due to financial disadvantage.
Accounts receivable can be explained as money, which potentially has to be paid by the customer for a particular purchase but is not compensated yet. As allowance reduces accounts, which will be unlikely to pay a particular sum, such a tool is considered to be a contra asset.
There are three major instruments that can be executed in order to estimate the allowance for doubtful accounts. The first instrument concerns risk classification and implies assigning to each customer a particular risk level and hence, assuming a higher risk of financial disability to those with higher risk levels.
The second type is rather diachronic as, according to it, a percentage of accounts with bad debts in the past should also be regarded as unreliable in the future. The third technique is called Pareto analysis, and it means that accounts that make up more than 80% of receivables should be analyzed in terms of their likeness to default. The rest of the accounts should be treated through the concept of historical percentage.