An allowance for doubtful accounts is a type of safeguard account established by many businesses. The main function of this kind of account is to provide a cushion against any customer invoices that remain unpaid for extended lengths of time. Companies typically base the amount of reserves that are maintained in the account on assessments of high risk clients and the probability that those clients will fail to honor those invoices.
It is important to note that the usual function of an allowance for doubtful accounts is not intended to cover the outstanding balances on invoices that are currently aged less than six months. Up to that point, collection efforts are normally made, including attempts to work out payment arrangements with customers who have undergone some sort of financial reversal. Many companies do not attempt to make use of the funds in the doubtful allowance account until it is determined that the outstanding balance is not likely to be collectable.
An example of when funds may be transferred from an allowance for doubtful accounts would be when a customer files for Chapter 7 bankruptcy protection. Upon notification that the customer has taken this type of action, all collection efforts must cease. This creates a situation where the company has no real assurances that they will ever be able to collect even part of the debt. This is especially true if the debt is not considered a priority by the courts, and will not be addressed at all until other creditors are considered and settled in some manner.
Accounting for an allowance for doubtful accounts is usually managed by creating a line item within the companies accounting records. The exact classification of the account will vary, depending on the prevailing accounting standards in the country where the company is based. Often, the account is managed as a line item within the operating budget or as a category within the Accounts Receivable, and structured to allow easy transfers into the Accounts Receivable balance when necessary.
While an allowance for doubtful accounts is a common strategy employed by large corporations, small businesses can also benefit from establishing this type of accounting line item. Having the reserves on hand, and a clear set of guidelines as to when those reserves can be used is extremely important. Many businesses also make sure that at least two corporate officers can authorize the transfer. Building up resources to offset debts that cannot be collected helps to ensure that the company can continue to honor its own debts, thus avoiding late fees or damage to the company’s credit rating.
