What it means
In business, selling on credit is essential for winning customers, but it always brings the risk of non-payment. Under standard accounting rules, you cannot simply wait until a customer officially declares bankruptcy to recognise the loss.
Instead, you must use the allowance method to forecast unpaid bills and record an estimated bad debt expense proactively. This keeps your balance sheet accurate by showing a realistic value for your accounts receivable, preventing you from overstating what you actually expect to collect.
Why does this matter for non-finance managers? Because it directly affects your reported profits and asset values.
If you ignore potential defaults, your profit looks artificially high today, only to take a sudden hit later when unpaid bills pile up. By estimating these losses early, you follow the matching principle of accounting, which pairs revenues with the costs required to generate them, including the cost of uncollected credit.
In practice, businesses usually calculate this allowance using historical averages or by ageing their receivables. The ageing method looks at how long invoices have been overdue, applying higher risk percentages to older balances.
Once calculated, you create a contra-asset account called allowance for doubtful accounts, which sits right below your accounts receivable on the balance sheet to offset the total amount. When a specific customer finally proves unable to pay, you do not record a new expense.
Instead, you simply write off the specific balance against the cushion you already created. This keeps your financial reporting smooth, predictable, and compliant with standard accounting frameworks, giving leaders a clear view of their true cash position.
In practice
Real-world examples.
Example
TechStart invoiced clients £10,000 this month. Based on past trends, management estimates that 5 percent, or £500, will never be paid. They record a bad debt expense and matching allowance for £500 immediately.
Example
BuildPro has £50,000 in outstanding customer invoices. Their ageing report shows that older bills carry a higher risk, so they set aside an allowance of £2,500 to cover anticipated defaults for this quarter.
Example
GreenLeaf Landscaping provides commercial services on credit worth £20,000. Anticipating that a few retail clients might struggle during winter, they establish an allowance of £1,000 to cover potential unpaid bills.
Think of it
“Imagine setting aside a small amount of cash each month for car repairs before something actually breaks, rather than waiting for a major breakdown to shock your bank account.
Formula
Calculation
Estimated Bad Debt = Total Credit Sales x Estimated Bad Debt Percentage. For example, if you have £100,000 in credit sales and your historical default rate is 3 percent, your calculation is £100,000 x 0.03 = £3,000 estimated bad debt expense.Case study
Seen in the real world.
BrightView Design, a growing digital agency, reached £200,000 in annual credit sales. Historically, about 4 percent of their billings went uncollected due to client cash flow issues. Using the allowance method, BrightView recorded an annual bad debt expense of £8,000 and established a corresponding allowance for doubtful accounts on their balance sheet. Mid-way through the year, a client owing £1,200 went out of business and could not pay. Instead of panicking or taking a sudden hit to that month's earnings, BrightView simply reduced their accounts receivable by £1,200 and cleared it against their existing allowance account. Their net income remained steady and realistic, proving the value of proactive accounting.
Watch out
Common mistakes.
- Waiting until a customer misses a payment before recording any expense.
- Using random guesswork instead of historical data to calculate the allowance percentage.
- Forgetting to subtract the allowance account from accounts receivable on the balance sheet.
Questions
People also ask.
Is the allowance method the same as writing off an account?
No. The allowance is an estimate of future losses. A write-off happens later when you identify a specific customer who will definitely not pay.
Which financial statements are affected by the allowance method?
Both the income statement, where the bad debt expense reduces profit, and the balance sheet, where the allowance reduces accounts receivable.
Can small businesses just wait until tax time to handle unpaid bills?
No, standard accounting principles require you to match expenses to the period the sale occurred, which means estimating bad debts regularly.
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