The allowance for doubtful accounts is an estimate a business carries on its balance sheet to reflect the portion of accounts receivable it does not expect to collect.1Internal Revenue Service. IRS Publication 538 – Accounting Periods and Methods Because accrual accounting recognizes revenue when you earn it rather than when cash arrives, this reserve keeps your financial statements from overstating what you’ll actually collect. Subtract it from gross receivables and you get net realizable value, the figure lenders, investors, and owners actually care about.
How the Account Works
The allowance is a contra-asset. It carries a credit balance that offsets the debit balance of accounts receivable, and the two together produce the net figure shown on the balance sheet. If your business holds $500,000 in receivables and estimates $15,000 will go uncollected, the balance sheet reports $485,000.
The logic comes from the matching principle. Expenses should land in the same period as the revenue they relate to, so if you sell on credit in January, the risk that some customers won’t pay is a January cost. Recording an estimated bad debt expense at that point, rather than waiting months for a specific invoice to fail, gives each period’s income statement an honest view of profitability.
Calculating the Allowance
Two methods dominate in practice. The right choice depends on how granular your receivables data is and whether your customers carry uniform or varied credit risk.
Percentage of Credit Sales
This approach applies a fixed percentage to total credit sales for the period. If historical data shows your business loses roughly 2% of credit sales to non-payment, you multiply the period’s credit sales by 0.02. A company with $1,000,000 in credit sales and a 2% loss rate would record $20,000 in bad debt expense.
It’s straightforward and works well when loss patterns are stable and customers look alike. The weakness: it focuses on the income statement and doesn’t directly calibrate the balance sheet reserve to what’s actually outstanding.
Aging of Accounts Receivable
The aging method starts with the receivables on the balance sheet and sorts them by how long they’ve been outstanding. Typical brackets are current, 1–30 days past due, 31–60, 61–90, and over 90. Each bracket gets a progressively higher estimated loss percentage. A debt 10 days past due might carry a 1% loss estimate; one over 90 days might carry 40% or more.
Multiply each bracket’s total by its loss rate and add them up. That total is your target balance for the allowance account. If the target is $25,000 and the existing allowance is $18,000, you record $7,000 in additional bad debt expense. The method keeps the balance sheet more accurate but requires more detailed tracking.
Adjusting for Current Conditions
Historical loss rates are a starting point, not an answer. If the economy is weakening, delinquency is climbing, or a major customer’s industry is contracting, your historical percentages probably understate the risk. Accountants are expected to adjust estimates for delinquency trends, changes in credit policies, regional economic shifts, and industry-specific conditions.2Farm Credit Administration. Applying GAAP in the Allowance Analysis Relying purely on backward-looking data is one of the most common errors auditors flag.
Recording the Provision
Once you have an estimate, the journal entry is simple. Debit bad debt expense and credit the allowance for doubtful accounts for the same amount. The debit reduces net income for the period. The credit increases the contra-asset, lowering the reported value of receivables.
For a quarter with $12,000 in estimated bad debt:
- Debit Bad Debt Expense $12,000
- Credit Allowance for Doubtful Accounts $12,000
No individual customer account is touched at this stage. You’re booking an estimate against the pool of receivables. The gross receivables balance stays the same; only net realizable value changes. Most businesses record this entry at least quarterly, in the same reporting period as the related sales.
Writing Off a Specific Uncollectible Account
When a specific customer’s balance turns out to be uncollectible, you remove it from active receivables by debiting the allowance and crediting the customer’s account. For a $3,000 write-off:
- Debit Allowance for Doubtful Accounts $3,000
- Credit Accounts Receivable (Customer X) $3,000
The write-off does not hit the income statement. The expense was already booked when you set up the allowance. This entry only moves an amount from “estimated uncollectible” to “confirmed uncollectible.” Both the asset and the contra-asset drop by the same amount, so net realizable value is unchanged.
When To Write Off
Common triggers include a customer bankruptcy filing, expiration of the statute of limitations for collecting the debt (which varies by state, generally four to ten years), or exhausting reasonable collection efforts. You don’t need to file suit if you can show a judgment would be uncollectible anyway.3Internal Revenue Service. Topic no. 453, Bad Debt Deduction The standard is whether any reasonable expectation of repayment remains.
Documenting the Debt
Documentation protects you during audits and when claiming a tax deduction. Keep records of the original sale, the due date, the debtor’s name and relationship to your business, every collection effort you made, and why you concluded the debt was worthless.3Internal Revenue Service. Topic no. 453, Bad Debt Deduction Correspondence with the debtor, notes from collection calls, and returned mail all serve as supporting evidence.
Recovering a Debt You Already Wrote Off
If a customer eventually pays a debt you’ve written off, the accounting takes two steps. First, reverse the write-off: debit accounts receivable, credit the allowance for doubtful accounts. That reinstates the customer’s balance. Second, record the payment: debit cash, credit accounts receivable. Two entries preserves the audit trail.
Recoveries can also create taxable income. Under the tax benefit rule, if you deducted the bad debt in a prior year and that deduction reduced your tax bill, you generally must include the recovered amount in gross income for the year you receive it.4Office of the Law Revision Counsel. 26 USC 111 – Recovery of Tax Benefit Items If the original deduction produced no actual tax benefit (for example, you had a net operating loss that year), the recovery is excluded from income to the extent of that “recovery exclusion.”5eCFR. 26 CFR 1.111-1 – Recovery of Certain Items Previously Deducted or Credited
The Allowance Isn’t Deductible for Taxes
This trips up a lot of business owners. The allowance method is required for GAAP financial reporting, but the IRS does not allow it on your tax return. For tax purposes you generally must use the specific charge-off method, meaning you can only deduct a bad debt when a specific account becomes worthless, not when you estimate future losses.6Internal Revenue Service. Publication 535, Business Expenses Your books will carry an allowance; your tax return won’t reflect those estimated losses until a real write-off happens.
A cash-method taxpayer faces an additional limit: you can only claim a bad debt deduction if the amount was previously included in income. Money you never reported earning isn’t deductible as a bad debt.
If You’re Subject to CECL
The traditional allowance approach described above is the incurred-loss model: you record losses when evidence suggests one has probably occurred. The Financial Accounting Standards Board replaced that framework with the Current Expected Credit Losses (CECL) model under ASC 326, which requires entities to estimate expected losses over the entire life of a receivable from the moment it’s recorded. You build forward-looking expectations into the allowance from day one, incorporating current conditions and reasonable forecasts alongside historical data.
For trade receivables, CECL allows a practical expedient called the provision matrix. You group receivables by shared risk characteristics and apply adjusted historical loss rates, provided you assess whether current conditions and supportable forecasts call for changes to those rates.7National Credit Union Administration. The Simplified CECL Tool For many small and mid-sized businesses, this looks similar in practice to the aging method, with a more explicit requirement to incorporate forward-looking information rather than relying purely on last year’s numbers.