What it means
The allowance exists because of matching. If a sale made in March eventually goes unpaid, the cost of that failure belongs in March alongside the revenue, not in the following year when the customer finally collapses.
It matters because receivables are usually among the largest assets a trading business owns. Reporting them at full face value when a slice will never arrive overstates both assets and profit, and lenders advancing money against the sales ledger price that risk very carefully.
There are two common ways to set the number. The percentage of sales method applies a historical loss rate to credit sales for the period, while the ageing method applies rising loss rates to each bracket of the receivables ledger and sets the allowance equal to the resulting total.
The mechanics confuse people, so it is worth being precise. Creating or increasing the allowance is an expense, but writing off a specific invoice later is not, because that write-off simply removes the receivable and the allowance together and leaves profit untouched.
The judgement involved makes it a favourite place to smooth results. An allowance quietly reduced in a weak year flatters profit without any change in the business, which is why auditors test the assumptions and compare the allowance against the write-offs that actually followed in previous years.
In practice
Real-world examples.
Example
A commercial cleaning company with $2,000,000 of credit sales and a 2% historical loss rate books a $40,000 bad debt expense each year. When one client fails owing $18,000, the write-off is absorbed by the allowance and profit is unaffected.
Example
A software reseller expands into a new sector with weaker credit quality. It raises its assumed loss rate from 1% to 3%, which triples the annual bad debt charge and prompts a tightening of credit checks on new accounts.
Example
An equipment hire business is acquired, and the buyer's due diligence finds the allowance has been unchanged at $25,000 for four years while receivables have doubled. The buyer reduces its offer to reflect an allowance that no longer matches the size of the ledger.
Formula
Calculation
Percentage of sales method: Bad debt expense = Credit sales x Historical loss rate
Movement on the account: Closing allowance = Opening allowance + Bad debt expense - Write-offs during the period
Worked example: a building supplies merchant makes credit sales of $5,000,000 during the year. Its history over the last five years shows that 1.5% of credit sales are never collected. The allowance brought forward from last year is $30,000, and during the year the company wrote off $10,000 of specific invoices from a customer that entered administration.
Bad debt expense = $5,000,000 x 0.015 = $75,000.
Closing allowance = $30,000 + $75,000 - $10,000 = $95,000.
If gross accounts receivable at the year end are $900,000, the balance sheet shows:
Net accounts receivable = $900,000 - $95,000 = $805,000.
The $75,000 expense reduces this year's profit, while the $10,000 write-off does not touch profit at all, because that cost was already recognised when earlier allowances were created.Case study
Seen in the real world.
The following is a fictional, illustrative case. Copperfield Trade Supplies, an invented builders' merchant, carried an allowance for bad debt of $18,000 against receivables of $1,100,000, a rate of well under 2%. Its actual write-offs over the previous three years had averaged $64,000 a year, so the allowance had been consistently and substantially too small.
When the auditors ran an ageing analysis, they found $210,000 sitting beyond 90 days, much of it owed by small contractors on projects that had already finished. Copperfield increased the allowance to $95,000, which reduced reported profit that year by $77,000 and triggered an uncomfortable conversation with its bank about a covenant. The illustrative point is that the correction was a reporting event rather than a business one: the money had already been lost, and the accounts had simply not yet admitted it.
Watch out
Common mistakes.
- Recording a bad debt expense when a specific invoice is written off, having already provided for it, which double counts the same loss.
- Leaving the allowance at the same figure year after year while the receivables ledger grows, so the provision falls further behind the risk.
- Confusing the allowance with a cash reserve, when it is only an accounting estimate and no money has been set aside anywhere.
Questions
People also ask.
Is the allowance for bad debt an asset or a liability?
Neither, strictly, because it is a contra asset account that sits against accounts receivable and reduces the reported value of that asset.
How do I choose a loss rate?
Start from your own write-off history over three to five years, then adjust for changes in customer mix, credit terms and economic conditions rather than relying on a single industry number.
What happens if the allowance turns out to be too large?
The excess is released back to profit in a later period, which increases reported earnings, and repeated large releases are a signal that the estimates were never realistic.
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