What it means
A business that sells on credit will not collect every invoice. Some customers fail, some dispute, some simply never pay.
If the business waited until each loss was certain before recording it, receivables would be overstated for months and the loss would land in a later period than the sale that caused it. The allowance method solves this by estimating the losses in advance.
At each period end the business assesses its receivables, decides how much is likely to go bad, and adjusts the allowance to that figure. The adjustment is the period's bad debt expense.
The estimate is usually built from an aging schedule, applying historical loss rates to each age band, adjusted for current conditions such as a recession or a troubled major customer. Specific provisions are added for individual balances known to be at risk.
Under current accounting standards (IFRS 9 and the US CECL model) the approach is forward-looking: businesses must estimate expected credit losses over the life of the receivable from the day it arises, using historical experience, current conditions and reasonable forecasts. The mechanics are simple.
Increasing the allowance: debit bad debt expense, credit allowance for doubtful accounts. Writing off a specific debt: debit allowance, credit accounts receivable, with no effect on profit because the expense was recognised when the allowance was raised.
Recovering a debt previously written off: reverse the write-off and record the cash. On the balance sheet, receivables are shown gross, less the allowance, giving net receivables.
The allowance is a judgement, and therefore a place where profit can be managed. An allowance that is too small overstates receivables and profit; one that is too large builds a hidden reserve that can be released to boost profit later.
Auditors test the estimate against the aging, subsequent collections and the company's history, and analysts compare the allowance as a percentage of receivables over time and across peers to spot changes in conservatism.
In practice
Real-world examples.
Example
A telecoms company with millions of small customers sets its allowance statistically, at 2.5% of receivables, based on years of collection data.
Example
A construction subcontractor provides in full for a $250,000 receivable from a main contractor that has stopped paying all its suppliers.
Example
A retailer offering store credit increases its loss rates on every age band when unemployment rises, in line with the forward-looking requirements of the accounting standards.
Think of it
“The allowance estimates how much of what customers owe you won't actually be paid.
Formula
Calculation
Required Allowance = Sum over age bands of (Balance in band x Expected loss rate) + Specific provisions for identified at-risk balances
Bad Debt Expense = Required Allowance at period end minus (Existing Allowance minus Write-offs during the period)
Net Receivables = Gross Receivables minus Allowance
Worked example. An office supplies distributor has gross receivables of $2,000,000 at year end and an allowance brought forward of $60,000. During the year it wrote off $45,000 of specific bad debts against the allowance, leaving $15,000.
Year-end assessment from the aging schedule:
- Current: $1,300,000 x 0.5% = $6,500
- 1 to 30 days: $400,000 x 3% = $12,000
- 31 to 90 days: $200,000 x 15% = $30,000
- Over 90 days: $100,000 x 50% = $50,000
- Subtotal from aging = $98,500
- Specific provision: a customer owing $60,000 (included in the 31 to 90 band) has entered administration; expected recovery 10%, so an additional provision of $60,000 x 90% minus the $9,000 already provided at 15% = $45,000
- Required allowance = $143,500
Bad debt expense for the year = $143,500 minus $15,000 = $128,500
Net receivables = $2,000,000 minus $143,500 = $1,856,500
Allowance as a percentage of gross receivables = 7.2%, up from 3.0% at the prior year end, which the notes to the accounts should explain.
Journal entries: debit bad debt expense $128,500, credit allowance $128,500. If in the following year the administrator pays $6,000 on the $60,000 debt and the rest is confirmed lost, $54,000 is written off against the allowance and the $6,000 is recorded as cash received.Case study
Seen in the real world.
A wholesale distributor had held its allowance for doubtful accounts at 1% of receivables for a decade because "that was the rate". Receivables had grown from $3 million to $9 million as the company extended credit to win business, and the over-90-day band had grown from 3% to 14% of the total. New auditors challenged the estimate, recalculated it from the aging at $620,000 against the $90,000 on the books, and required a $530,000 increase, which wiped out the year's profit.
The company's bank, seeing the restated position, reduced its receivables-based facility. The distributor's response over the following year was to build a proper credit function: credit checks and limits for every customer, a monthly aging review with the allowance recalculated each quarter, and a policy that no customer over 60 days receives further supply. Bad debts fell by two thirds the following year, and the allowance, now recalculated from evidence, became a number the auditors, the bank and the board all trusted.
Watch out
Common mistakes.
- Setting the allowance as a flat percentage and never revisiting it. The estimate should follow the aging and current conditions.
- Recording a write-off as bad debt expense when an allowance already covers it, which double-counts the loss.
- Using the allowance to smooth profit, building it up in good years and releasing it in bad ones.
Questions
People also ask.
What is the difference between the allowance and a write-off?
The allowance is an estimate of future losses across the receivables. A write-off removes a specific uncollectable balance, charged against the allowance.
Is the allowance a liability?
No. It is a contra-asset: it reduces receivables on the asset side of the balance sheet.
What is expected credit loss?
The current standard approach: an estimate of the losses expected over the life of a receivable, made from the day it is recognised using history, current conditions and forecasts, rather than waiting for evidence of default.
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