Definition and purpose
– The allowance for doubtful accounts (also called allowance for bad debts) is a management estimate of the portion of accounts receivable (AR) that a company does not expect to collect.
– It is recorded as a contra-asset on the balance sheet, which reduces the gross AR balance to a realistic net realizable value.
– The allowance supports conservative, accrual-based reporting: expected losses are recognized in the same period as the related sales rather than when individual customers default.
How the allowance works (basic mechanics)
– When a company estimates uncollectible receivables, it records a bad debt expense (income statement) and increases the allowance for doubtful accounts (contra-asset on the balance sheet).
– When a specific customer balance is deemed uncollectible, the company writes it off by reducing both AR and the allowance—this does not change expense at the write-off moment.
– If a previously written-off account is later collected, the company reverses the write-off (restores AR and the allowance) and then records the cash receipt.
Core journal entries (typical)
– To record the estimate (provision):
Debit: Bad Debt Expense
Credit: Allowance for Doubtful Accounts
– To write off a specific account:
Debit: Allowance for Doubtful Accounts
Credit: Accounts Receivable
– To record recovery of a previously written-off account (two-step):
1) Reverse the write-off — Debit AR, Credit Allowance
2) Record cash collection — Debit Cash, Credit AR
Common estimation methods (how to estimate the allowance)
1) Percentage of sales method
– Apply a single historical percentage to credit sales for the period.
– Bad debt expense = Credit sales × Estimated uncollectible percentage.
– Simple and suitable when default rates are stable.
2) Accounts receivable aging method (aging schedule)
– Group receivables by age (e.g., 0–30, 31–60, 61–90, >90 days) and apply larger uncollectible percentages to older buckets.
– The target allowance is the sum of (balance in each age bucket × bucket-specific percentage).
– This method ties the allowance to the current composition of receivables.
3) Risk classification (segmentation)
– Segment customers by observable risk characteristics (industry, geography, credit score, customer type) and apply different loss rates to each segment.
– Useful when payment behavior differs markedly across customer groups.
4) Historical percentage method
– Use long-run average uncollectible rates based on company history.
– Works best when business mix and economic conditions are stable over time.
5) Pareto analysis (concentration approach)
– Focus analytical effort on the relatively small set of large accounts that make up most of AR (80/20 principle).
– Assess major accounts individually; apply a standard rate to smaller accounts.
6) Specific identification
– Review individual customer accounts and set allowance amounts for known risks (e.g., bankruptcies, litigation).
– Most precise but time-consuming; often blended with other methods.
Practical tips and caveats
– Consistency: Frequent, unexplained changes in methodology or material shifts in the allowance may draw scrutiny from auditors and analysts.
– Economic sensitivity: Allowance levels should reflect current economic conditions and customer credit trends, not only historical averages.
– Documentation: Maintain support for chosen percentages, aging assumptions, and customer-specific judgments.
– Use a combination: Many companies blend methods (aging + historical rate + specific identification) for a balanced estimate.
Key formula (ending allowance)
Ending allowance = Beginning allowance + Provision for bad debts − Write-offs + Recoveries
Short checklist for preparing or reviewing an allowance
1) Gather current AR by invoice age and customer segments.
2) Review historical collection and write-off experience.
3) Select applicable estimation method(s) and justify the choice.
4) Calculate the target allowance and compare to current balance.
5) Record the provision or reversal to align to the target allowance.
6) Document assumptions, data sources, and any customer-specific judgments.
7) Monitor material changes and disclose significant policy changes in financial statements.
Worked numeric example
Situation: A merchant has $200,000 of credit sales this quarter and $150
,000 of accounts receivable at quarter‑end. Beginning allowance for doubtful accounts = $3,000. During the quarter the company wrote off $1,200 of receivables and recovered $300 on accounts previously written off. The finance team uses (a) a percent‑of‑sales rule (income‑statement approach) at 1.5% and (b) an aging schedule (balance‑sheet approach) that implies 4% of ending receivables.
Step 1 — Percent‑of‑sales (income‑statement) approach
– Provision = Credit sales × estimated bad‑debt rate
– Provision = $200,000 × 1.5% = $3,000
– Journal entry (simplified): Debit Bad Debt Expense $3,000; Credit Allowance for Doubtful Accounts $3,000.
– Ending allowance (check using the formula ending allowance = beginning allowance + provision − write‑offs + recoveries):
– Ending allowance = $3,000 + $3,000 − $1,200 + $300 = $5,100.
– Impact: Bad Debt Expense for the quarter increases by $3,000; allowance (contra‑asset) on the balance sheet is $5,100.
Step 2 — Aging (balance‑sheet) approach
– Target ending allowance = Ending AR × aging‑implied rate
– Target = $150,000 × 4% = $6,000
– Required provision (to reach the aging target)
– Use the reconciliation formula: ending allowance = beginning allowance + provision − write‑offs + recoveries.
– Solve for provision: provision = target ending allowance − beginning allowance + write‑offs − recoveries.
– Numbers: provision = $6,000 − $3,000 + $1,200 − $300 = $3,900.
– Journal entry (aging / balance‑sheet approach)
– Debit Bad Debt Expense $3,900
– Credit Allowance for Doubtful Accounts $3,900
– Check (ending allowance)
– Ending allowance = $3,000 + $3,900 − $1,200 + $300 = $6,000 (matches aging target).
– Compare the two methods (quick summary)
– Percent‑of‑sales (income‑statement) approach produced a provision of $3,000 and an ending allowance of $5,100.
– Aging (balance‑sheet) approach requires a provision of $3,900 to reach the targeted $6,000 allowance.
– The difference ($900) reflects the two methods’ focus: percent‑of‑sales targets expense based on current period sales; aging targets the balance‑sheet reserve needed to cover estimated collectible losses on existing receivables.
– Practical implications and guidance
– Which number goes on the financial statements?
– The allowance shown on the balance sheet should equal the target (here, $6,000) after you post the appropriate provision. The income statement shows the Bad Debt Expense that was recorded in the period (either $3,000 or $3,900 depending on which method management uses).
– Documentation checklist before recording:
1. Confirm beginning allowance, write‑offs, and recoveries from the subsidiary ledger and prior period closing entries.
2. Run an AR aging and apply the assumed uncollectible percentages by age bucket.
3. Calculate the target allowance from the aging schedule.
4. Compute required provision using the reconciliation formula.
5. Prepare the journal entry and supporting workpapers; note assumptions and percentage drivers.
6. Disclose method(s) and significant changes in accounting estimates in the footnotes (GAAP/IFRS requirement).
– Common practices:
– Many firms use the aging method to set the ending allowance (balance‑sheet focus) and use percent‑of‑sales for trend analysis. If the two give materially different provisions, management should document reasons (changes in customer mix, macro conditions, new loss experience).
– Current U.S. GAAP requires entities to use an expected credit loss model (ASC 326) for many financial instruments, which emphasizes forward‑looking information. Check applicable standards for your entity.
– Quick numeric recap (for this example)
– Beginning allowance: $3,000
– Credit sales (for percent‑of‑sales calc): $200,000; percent used: 1.5% → provision = $3,000
– Ending AR: $150,000; aging rate: 4% → target allowance = $6,000 → provision required = $3,900
– Write‑offs during period: $1,200; recoveries: $300
– Ending allowance if