The allowance method for bad debts records an estimated loss against your receivables in the same period you book the sale, rather than waiting for a specific customer to default. You do it with two accounts: Bad Debt Expense on the income statement and a contra-asset called the Allowance for Doubtful Accounts on the balance sheet. When a particular account later goes bad, you charge it against the allowance instead of taking a fresh hit to earnings. This is the method U.S. GAAP requires whenever uncollectible amounts are material.
How the Two Accounts Work Together
Accounts receivable sits on your balance sheet at its gross amount. The Allowance for Doubtful Accounts sits right below it as a deduction. Gross receivables minus the allowance equals Net Realizable Value, the figure that represents what you actually expect to collect.
A quick example. Receivables of $500,000 paired with a $15,000 allowance show a net receivable of $485,000. That $485,000 is the number investors and lenders rely on, because the $500,000 includes dollars you already know, in the aggregate, won’t come in.
You build the allowance with a period-end adjusting entry: debit Bad Debt Expense, credit Allowance for Doubtful Accounts. The expense reduces reported profit in the same period the sale was recorded. That timing is the whole reason the method exists.
Estimating the Allowance
How big that adjusting entry needs to be depends on how you estimate future losses. Two traditional approaches dominate, and they reach the answer from opposite directions.
Percentage of Sales
Start with the income statement. Apply a fixed percentage, drawn from your historical collection data, to net credit sales for the period. If roughly 1.5 percent of your credit sales eventually go unpaid and you booked $800,000 in credit sales this quarter, you record $12,000 in bad debt expense.
The entry is $12,000 regardless of what balance the allowance already carries. That makes the method clean and consistent quarter to quarter, but the allowance can drift above or below its ideal level over time. Most companies that use this approach periodically true it up against the receivables aging.
Aging of Receivables
The aging method works backward from the balance sheet. Sort every open receivable into buckets by how far past due it is, then assign each bucket an estimated loss rate that rises with age. A current invoice might carry a 1 percent expected loss; an invoice more than 90 days overdue might carry 40 percent.
Multiply each bucket’s balance by its loss rate, add the results, and that total becomes the target ending balance for the allowance. The adjusting entry is whatever moves the allowance from its current balance to that target. If the target is $18,000 and the allowance already shows a $2,000 credit, you book $16,000. If the allowance has a $1,000 debit balance because prior write-offs exceeded prior estimates, you book $19,000.
Aging tends to produce a tighter estimate because it ties directly to the composition of your receivables on the reporting date. Auditors generally prefer it for that reason.
Writing Off a Specific Account
The adjusting entry anticipates losses in the aggregate. The write-off records one when it actually arrives. Once you determine that a particular customer will never pay, whether after failed collection efforts, a bankruptcy, or a lapsed statute of limitations, you remove the balance.
Debit Allowance for Doubtful Accounts, credit Accounts Receivable. Bad Debt Expense does not appear. The expense was already recognized when the allowance was built; the write-off just uses the reserve.
Here is the part that trips people up: the write-off does not change Net Realizable Value. Gross receivables and the allowance both drop by the same amount, so the net stays the same. Receivables of $500,000 with a $15,000 allowance become $495,000 with a $10,000 allowance after writing off a $5,000 account. Still $485,000 net.
Recovering an Account You Already Wrote Off
Occasionally a written-off customer pays. Two entries are needed because you have to put the receivable back on the books before you can apply cash to it.
First, reinstate the account: debit Accounts Receivable, credit Allowance for Doubtful Accounts. Then record the payment: debit Cash, credit Accounts Receivable. Bad Debt Expense is not touched in either step. Reinstating the receivable also restores the customer’s record in your books, which matters if you later consider extending credit to them again.
When You Change Your Estimate
Loss rates shift. Your customer mix changes, the economy turns, or your collection practices tighten. When you revise the percentages or the methodology, GAAP treats the revision as a change in accounting estimate, applied prospectively. You record the effect in the current period and going forward, and you do not restate prior financial statements.
If your aging analysis now shows the 61–90 day bucket defaulting at 25 percent instead of last year’s 15 percent, you adjust the allowance this period. Prior periods were reported with the best information then available, and rewriting them would create more confusion than clarity.
CECL: The Forward-Looking Overlay
The traditional estimation techniques lean on historical loss rates. In 2016 the Financial Accounting Standards Board issued ASC 326, the Current Expected Credit Loss standard, which changed what goes into the estimate. Public companies adopted it starting in 2020; private companies followed in 2023.
CECL requires you to estimate expected credit losses over the full remaining life of the receivable, not just losses you believe have already been incurred. The estimate must weave together three layers: historical loss experience, current conditions, and reasonable and supportable forecasts of the future.1Financial Accounting Standards Board (FASB). FASB Staff Q&A Topic 326, No. 2: Developing an Estimate of Expected Credit Losses On Financial Assets That third layer is what sets CECL apart from the older incurred-loss model. If your industry is heading into a downturn and your customers’ credit profiles are weakening, your allowance should reflect that even if your historical write-offs have been low.
The standard does not force a single calculation. An aging schedule, a loss-rate approach, a probability-of-default model, discounted cash flow, or a combination all remain available, provided the inputs reflect lifetime expected losses adjusted for forecasted conditions. For periods beyond which you can reasonably forecast, you revert to unadjusted historical loss rates.1Financial Accounting Standards Board (FASB). FASB Staff Q&A Topic 326, No. 2: Developing an Estimate of Expected Credit Losses On Financial Assets Smaller companies are not exempt, but regulators expect the standard to be scaled; adjusting existing aging percentages for observable economic trends can satisfy the requirement for simpler operations.2Federal Reserve Board. Frequently Asked Questions on the New Accounting Standard on Financial Instruments – Credit Losses
Your Tax Return Doesn’t Use the Allowance Method
The IRS does not accept the allowance method. Congress repealed the reserve method for tax purposes in 1986, and Section 166 of the Internal Revenue Code has since required taxpayers to deduct bad debts only when specific debts become wholly or partly worthless.3Office of the Law Revision Counsel. 26 USC 166 – Bad Debts So your financial statements run on the allowance method while your tax return runs on direct write-off.
Proving a debt is worthless for tax purposes takes evidence rather than an estimate. The IRS weighs factors like whether the debtor filed bankruptcy, abandoned the business, repeatedly ignored collection attempts, or has no assets to reach, and it expects you to have made reasonable collection efforts first.4Internal Revenue Service. Topic No. 453, Bad Debt Deduction No single factor is decisive; worthlessness is judged on the totality of circumstances.5Internal Revenue Service. Section 166 – Deduction for Bad Debts
Because your books recognize bad debt expense before the IRS allows the deduction, a timing gap opens between book income and taxable income. On a corporate return the difference appears on Schedule M-1, or Schedule M-3 for larger filers, as an expense on the books but not on the return.6Internal Revenue Service. Chapter 10 Schedule M-1 Audit Techniques That same gap creates a deferred tax asset, which unwinds in the later period when the specific debt actually qualifies for a deduction.
Why GAAP Doesn’t Let You Just Wait
The direct write-off method skips estimation. You record no expense until a specific customer defaults, at which point you debit Bad Debt Expense and credit Accounts Receivable. Simple, and that is exactly why it fails for financial reporting.
The problem is timing. A December sale might not produce a write-off until the following August. Revenue lands in one year and the loss in the next, which overstates income in the first year and understates it in the second. The allowance method exists to prevent that mismatch. GAAP permits direct write-off only when uncollectible amounts are so small relative to revenue that the distortion is immaterial.
For most companies, then, the two systems run in parallel: allowance method on the books, direct write-off on the return. They converge in the end, because every dollar of estimated bad debt expense eventually becomes a deductible worthless debt, but the gap in any given year moves both your reported earnings and your tax bill.