What it means
When a company sells on credit, some customers will not pay, because they go bust, dispute the invoice or simply disappear. The business does not know which customers, but experience tells it roughly what proportion will fail.
The allowance records that expectation in advance. The allowance is a contra-asset account, which means it sits beside accounts receivable and reduces it.
The balance sheet shows receivables at their gross amount, then deducts the allowance to give net receivables. No individual customer is written off at this stage, because the allowance is a general reserve.
Setting the allowance is an estimate. Companies often use the percentage of receivables method, applying a rate to the total, or the ageing method, applying higher rates to older balances.
The rates come from the company's own history, adjusted for current conditions such as the economy and any customers in difficulty. Each period, the company adjusts the allowance to the required level and records the change as bad debt expense on the income statement.
When a specific debt is later judged uncollectible, it is written off against the allowance, which reduces both receivables and the allowance but has no further effect on profit. If a customer later pays a debt that was written off, the write-off is reversed.
Accountants should be careful about using the allowance to manage profit. Over-provisioning in good years and releasing it in poor years smooths earnings artificially, and auditors watch for it.
Estimates should be consistent and supported by evidence. Accounting standards have changed how the estimate is framed.
Newer rules in some jurisdictions ask companies to estimate expected credit losses over the life of the receivable, using forward-looking information as well as past experience. The practical effect is that the reserve is booked earlier and tends to move with the economic outlook.
In practice
Real-world examples
Example 1
A building materials supplier sees 2% of its credit sales go unpaid every year. At year end it sets the allowance at 2% of receivables. Profit for the year includes the expected loss, even though the unpaid invoices have not yet turned bad.
Example 2
A medical practice invoices insurers and patients. It sets a higher percentage for patient balances older than 90 days than for insurer balances. The allowance matches the risk of each group, and the practice reviews the rates once a year.
Example 3
A software company learns that a major customer has entered bankruptcy and owes $60,000. It increases the allowance by that amount at once. The year's accounts then show the expected loss, and the finance team keeps the paperwork on the bankruptcy for the auditors.
Think of it
The allowance estimates how much of what customers owe you won't actually be paid.
Formula
Calculation
Required allowance = Accounts receivable x Estimated uncollectible percentage
Bad debt expense = Required allowance - Existing allowance balance (credit)
A company has accounts receivable of $400,000 and estimates that 3% will not be collected. Required allowance = $400,000 x 3% = $12,000. The allowance account currently has a credit balance of $4,500. Bad debt expense for the period = $12,000 - $4,500 = $7,500, and net receivables are $400,000 - $12,000 = $388,000.Case study
Seen in the real world
Brookfield Timber is a fictional wholesaler that, in this illustrative story, had receivables of $1,000,000 and no allowance for doubtful accounts because the owner never wrote off a debt until it was certain. In a single year, three customers went out of business owing a combined $120,000.
Because nothing had been reserved, profit that year fell by the full $120,000, and the owner was surprised by the drop. A lender who relied on the accounts asked why the earlier year's profit had looked so strong.
The accountant introduced an allowance of 2.5% of receivables, based on five years of history, and reviewed it every quarter. Bad debts now flowed through the profit and loss account steadily, and the figures gave the lender a more reliable picture. The owner also began asking larger new customers for credit references.
Watch out
Common mistakes
- Waiting to record bad debts until a customer is formally written off. This overstates profit in the meantime.
- Setting the allowance at an arbitrary figure. It should rest on past experience and current conditions.
- Treating the allowance as cash set aside. It is only a bookkeeping reserve that reduces the receivables figure.
Questions
People also ask
Is the allowance an asset or a liability?
It is a contra-asset, so it reduces accounts receivable. It is shown within current assets, as a deduction from gross receivables.
What is the difference between the allowance and bad debt expense?
The allowance is a balance sheet reserve, while bad debt expense is the income statement charge for the period. The expense builds up the allowance.
What happens when a specific debt is written off?
The debt is removed from receivables and charged against the allowance. Profit is not affected again because the cost was already recognised.
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