Allowance for Bad Debt: Definition and Overview
An allowance for bad debt (also called allowance for doubtful accounts) is a contra-asset valuation account used to estimate the portion of a company’s accounts receivable that will not be collected. It reduces the gross receivable balance to a realistic net realizable value and matches expected credit losses to the same period as the related sales.
Why it Matters
- The face value of accounts receivable overstates collectible cash; some customers will not pay.
- Recording an allowance ensures financial statements present a more accurate asset value and matches expenses (bad debt expense) with the revenues that generated the receivables.
- Accurate allowances are important for users of financial statements and for regulatory compliance.
Common Estimation Methods
There are two primary approaches to estimating the allowance:
Explore More Resources
- Sales (Income Statement) Method
- Estimates bad debts as a percentage of credit sales for the period.
- Simple and suited for companies with stable historical loss rates.
-
Example: $1,000,000 in credit sales × 1.5% uncollectible = $15,000 bad debt expense.
-
Accounts Receivable (Balance Sheet) / Aging Method
- Evaluates receivables by age; older receivables receive higher estimated loss rates.
- Produces a target allowance balance based on the composition of outstanding receivables.
- Example aging schedule:
- Current receivables — 1% uncollectible
- 30 days past due — 10% uncollectible
- 90+ days past due — 50% uncollectible
- More accurate for firms with diverse receivable aging profiles.
Accounting Treatment and Journal Entries
- To record estimated bad debts (using whichever method is chosen):
- Debit Bad Debt Expense
-
Credit Allowance for Doubtful Accounts (contra-asset)
-
When a specific receivable is confirmed uncollectible (write-off):
- Debit Allowance for Doubtful Accounts
- Credit Accounts Receivable
These entries leave net accounts receivable reduced and match expenses to the appropriate period.
Adjustments and Defaults
- The allowance should be adjusted periodically to reflect updated estimates of uncollectible receivables.
- Example: If estimated at-risk loans are $2,000,000 and the allowance currently has a $1,000,000 balance, an adjusting entry would record $1,000,000 additional bad debt expense to bring the allowance to $2,000,000.
- When a specific loan or receivable is confirmed in default, the company writes it off against the allowance rather than recording a new expense.
GAAP Guidance and Practical Considerations
- Under GAAP, the allowance must reasonably reflect the firm’s historical collection experience and current conditions.
- Established firms typically use their own history; new businesses rely on industry averages or comparable companies until historical data accumulate.
- An accurate allowance is necessary to determine the true value of accounts receivable and present reliable financial statements.
Key Takeaways
- The allowance for bad debt is a contra-asset that adjusts accounts receivable to net realizable value.
- Two main estimation approaches are the sales method (percent of credit sales) and the aging/accounts receivable method.
- Record estimated bad debts as an expense and credit the allowance; write-offs debit the allowance and credit receivables.
- Regular adjustments and reasonable estimates are required under GAAP to reflect expected credit losses.