Allowance for doubtful accounts is a contra asset; its balance is added to accounts receivable.

When determining how much uncollectible customer debt to write off, an associated account called a contra account is used. This helps to keep financial books straight while also allowing the company to see the amount in doubtful accounts. 

What is contra account? Contra means against. This type of account is used to offset an asset account. Since we are discussing doubtful accounts, the offset will be against accounts receivables. 

How Does A Contra Account Work?

Accounts receivable is usually a debit balance. It's contra asset account, called allowance for doubtful accounts, will have a credit balance. When you add these two balances together, they offset each other, revealing the amount possible to collect in accounts receivable. In other words, the net accounts receivable amount. This happens because the contra asset account has already accounted for bad debts or those that are not likely to be collected. Those bad debts are simply subtracted out of accounts receivable.

It isn't normal to have a credit balance on an asset account. This is another reason allowance for doubtful accounts is referred to as a contra asset account. The contra account's credit balance keeps it from violating the cost principle.

One advantage to using an allowance account is that it can keep track of information related to each doubtful account. While this information doesn't come out in financial statements, it isn't lost either. Some of this documentation will include specific customers along with the uncollected amount for each. Such information can be useful for determining future credit, pursuing future debt collection, or even if you want to keep a customer.

Additionally, you can glean information about these doubtful accounts such as: industry, age of business, size of business, net invoice due terms, early payments, etc. Each bit of information on its own doesn't say much. But when multiple pieces of information are combined, it can help to build a picture of various types of businesses that may be high risk. 

Knowing a business is high risk can help in building a more robust debt collection policy.

Financial Statement and Bookkeeping Examples

To really understand how contra accounts work, we're going to look a few examples. Below are some examples of what the contra asset account entries look like on the balance sheet and in trial balance bookkeeping form.

Let's assume we've identified accounts receivable bad debt of $1000. An entry for $1000 as a credit will also need to be made into the Allowance for Doubtful Accounts. Below is what the balance sheet may look like:

Current Assets
Accounts receivable                              $3000
  Less allowance doubtful accounts   $1000           
    Net accounts receivable                              $2000

To complete the transaction, there is also an expense account involved. A debit entry of $1000 into Bad Debts Expense should be made.  This number will come out on the income statement, not the balance sheet.

In a trial balance, it will look like this:

Account                                                       Debit    Credit    Account Info
Accounts receivable account.                  3,000                   Asset account
Allowance for doubtful debts account.               1,000     Contra asset account

You can see in the above examples that the amount not collected from the customer is well documented. This allows the company to know the amount uncollected from each customer. Such information can be used in the future to try and collect on outstanding debt.

Keep in mind that allowance for Doubtful Accounts is often an estimate. Although sometimes, it may be an exact figure, as we'll see below.

Writing Off Bad Debt

Now that we now what a contra asset account is and how to create entries in it, when exactly should these entries be made. Your accounts receivable or credit policy should tell you when it is time to write off a debt that can't be collected.

If your credit policy doesn't reflect when to write off bad debt, below are a few tips that can help get you started. 

Determine the max days you want to carry uncollected debt. If your max net days is 90, meaning some customers have 90 days before payment on invoices are due, overdue invoices might go into an allowance doubtful situation after 150 days. The client's payment history and status of communication should also be taken into consideration.

Of course, if a client has filed for bankruptcy, any amounts owed will likely have to go into uncollectible status.

Clients may have special situations as well. If a client has communicated that they know there isn't a chance of being able to pay your invoice, this is also reason to put their account into doubtful account status.

By writing off the debt through allowance for doubtful accounts, outstanding accounts receivable will be reduced. Be sure not to record the bad debt expense again.

Integrating Allowance Accounts into your Accounting System

As we've seen, a contra asset account isn't a complex addition to your accounting system. 

It does offer many advantages. Two main advantages include:

• Ability to document uncollectible debt for each customer
• Provides a more accurate picture of accounts receivable

Overall, contra asset accounts can improve your accounting system, particularly cash flow projections.

Is allowance for doubtful accounts a contra account to accounts receivable?

What is the type of account and normal balance of allowance for doubtful accounts a contra asset credit?

What if allowance for Doubtful accounts has a credit balance?

Where is allowance for doubtful accounts on balance sheet?