Every business that sells on credit eventually meets a customer who never pays. If you wait until that happens to record the loss, your profit looks better than it really is. An allowance for doubtful accounts fixes this by estimating the loss in advance. This Q&A explains how it works and how to calculate it with nothing more than a spreadsheet.
What is an allowance for doubtful accounts?
It is a contra-asset account that sits next to accounts receivable on the balance sheet. It holds your best estimate of the invoices you will not collect. Receivables minus the allowance gives the net amount you realistically expect to receive. Because the estimate is booked in the same period as the sale, neither your income nor your assets are overstated.
Which methods can you use?
Two are common. The aging method starts from the receivables balance, and the percent-of-sales method starts from the income statement. Most small businesses pick one, document it and stay consistent.
How does the aging-bucket method work?
Group open invoices by how overdue they are, then apply a loss percentage to each group based on your own history. Older invoices are less likely to be paid, so the rate rises with age. Here is a worked example:
- Not yet due: $60,000 at 1% = $600
- 1 to 30 days overdue: $20,000 at 3% = $600
- 31 to 60 days overdue: $10,000 at 10% = $1,000
- Over 60 days overdue: $5,000 at 30% = $1,500
Total receivables are $95,000 and the required allowance is $3,700. If the allowance already has a $1,200 credit balance, you only add $2,500 this period to bring it to the target. Your percentages should come from your own data: look at what share of invoices in each bucket were never collected over the past two or three years.
How does the percent-of-sales method work?
Multiply credit sales for the period by the percentage that has historically gone bad. If you made $400,000 of credit sales this quarter and 1.2% of past credit sales were never collected, bad debt expense is $4,800. It is quick and matches expense to revenue, but it ignores the current state of your receivables, so a check against an aging report is wise.
What is the journal entry?
In words: you debit bad debt expense and credit the allowance for doubtful accounts for the amount of the estimate. The expense reduces profit this period, and the credit lowers net receivables on the balance sheet. With the aging method, the amount is the difference between the target allowance and the balance already there. With percent of sales, it is the calculated amount itself.
How often should you review it?
Review it every quarter, and at year end before you close the books. Each time, rerun your aging report, compare the allowance with what actually happened, and adjust the percentages if customers are paying faster or slower than before. Also revisit it whenever something changes: a large customer in trouble, a new payment term, a shift in the economy or a new sales channel. If actual losses keep landing far from your estimate, the percentages are wrong, not unlucky.
How is it different from a write-off?
The allowance is an estimate made before you know which customers will not pay. A write-off happens when a specific invoice is confirmed as uncollectible. At that point you debit the allowance and credit accounts receivable for that invoice. No new expense is recorded, because the cost was already booked when you created the allowance, and net receivables stay the same. If the customer later pays, you reverse the write-off and record the cash received.
What mistakes should you avoid?
- Using a flat rate for everything. A 90-day-old invoice and one due next week are not equally risky.
- Never updating the percentages. Rates from three years ago may not match today's customers.
- Recording a write-off as an expense. That counts the same loss twice.
- Ignoring one large account. A single risky customer can be reserved for individually instead of by a bucket rate.
- Skipping the collection effort. A good allowance is a safety net, not a substitute for chasing payment.
Where do you start?
Export your open invoices, sort them into aging buckets, work out the historical loss rate for each and book the first entry. Then put a recurring quarterly review in your calendar. The best way to keep the allowance small is to collect faster, and Collection (FulcrumGrid) can help there by tracking overdue invoices, follow-up reminders and promised payment dates in one place, so your aging report is cleaner to begin with.
Frequently asked questions
Is the allowance for doubtful accounts an asset or a liability?
It is a contra-asset account. It carries a credit balance and is subtracted from accounts receivable, so it reduces your total assets rather than appearing as a liability.
What percentage should I use for each aging bucket?
Use your own history. Calculate what share of invoices in each age group were never collected over the last two or three years, and adjust for any known changes in customers or terms.
Does a write-off reduce profit again?
No. The expense was recorded when you created the allowance. A write-off only moves the amount out of both the allowance and accounts receivable.
Can I use both the aging and percent-of-sales methods?
Yes. Many businesses use percent of sales for quick monthly estimates and the aging method each quarter as a check, then adjust the allowance to the aging result.
FulcrumGrid Collection
Collect faster, reserve less
Collection (FulcrumGrid) keeps overdue invoices, follow-ups and payment promises in one place, so fewer receivables age into doubtful territory.