One difficult aspect of being an accountant, or a businessperson of any kind, is not knowing whether a client is going to pay a debt owed for goods or services rendered and, if so, when?
In fact, failure to pay is such a common occurrence that wise accountants have started to factor this into their company’s budget and revenue reports.
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Let’s talk about how these delinquent accounts are factored in, and how doing so can help you create a healthier budget.
What is allowance for doubtful accounts?
Allowance for doubtful accounts is the amount of money you anticipate clients will either pay late or will never pay, and subtract from overall revenue so as to get an idea of what your actual revenue will be at the end of a reporting cycle.
As you can probably tell from the title above, being financially prepared for late or unpaid bills is called “allowance for doubtful accounts.” It is the act of estimating who won’t pay, what amount they won’t pay, and how this will affect your organization’s bottom line.
Managers and accountants add up the sum of what they estimate will not be paid, and subtract this sum from accounts receivable. The end result is a realistic estimate of what will actually be paid.
Why calculate this allowance?
Say your parents promise to give you $20 for mowing the lawn, so you do it, but they only have a $10 bill, and they promise to “pay you back next week.” You now can’t go to the movies like you planned, because your debtors (parents) did not pay their invoice (give you the lawn-mowing money) in full.
Can you imagine how much worse it is when this happens to a business? When a client fails to pay a large invoice as anticipated , you are unable to give holiday bonuses, or complete office renovations, or roll out the new software you wanted.
Creating an allowance for doubtful accounts helps companies keep track of current or future bad debts, or receivables that customers do not intend to pay. Keeping track of bad debts is important because it creates a more accurate picture of what your company is receiving when it makes a sale.
Many companies choose to calculate the allowance for doubtful accounts as soon as they record a sale. For example, if you sell $5,000 worth of services to a client that typically falls five percent short in payments, just proactively prepare to not get that five percent.
By creating an allowance for this shortage, you’re able to budget around it and not become surprised when that money does not show. In a balance sheet, you would display the allowance as a separate account that offsets the sale.
When in doubt
Failed payments aren’t ideal, but they happen. Your organization is better off preparing for them so you can still follow through with other business plans.
If you decide to seek legal action for the remainder of your payments, that’s up to you and your organization. But the least you can do is prepare for one unfortunate reality of business by calculating an allowance for doubtful accounts.
Check out What Is Financial Accounting to learn more about the accounting process.