How does the allowance for doubtful accounts work?

Definition

The allowance for doubtful accounts is a contra-asset reserve that reduces receivables for the share you do not expect to collect. It is not cash set aside in a bank account, and it is not a customer's unpaid invoice.

On the books, it sits against accounts receivable so current assets on the Balance Sheet are not overstated. The related P&L charge is bad debt expense.

Gross invoices tell you what you billed. The allowance is the estimated slice of that total that will probably never come in.

Where it shows up

Balance Sheet: Located in the current assets section, as a reduction of receivables.

P&L: Related to bad debt expense.

See also: Accounts Receivable · Bad Debt Expense · Accounts Receivable Aging

When you look at your Balance Sheet, the allowance appears in current assets as a reduction of accounts receivable. Some packs show it as its own line under receivables; others fold it in and print only the net amount.

A large allowance relative to gross invoices means you expect a sizable share not to pay. A small allowance can mean clean collections, or an estimate that is behind the aging.

The profit and loss statement does not list the allowance as a line. The related expense is bad debt, which usually sits in operating expenses.

This reserve is typically a non-cash estimate. Funding it does not move the bank account, and using it to write off an invoice does not move cash either.

Aging reports often feed the estimate. Older buckets usually support a larger allowance than invoices that are still current.

How it works

You start from the open invoices. The allowance is the credit balance you hold against that gross total.

At period end you estimate how much of the receivable book will not be collected. Many books use history, a percentage of outstanding invoices, or the aging buckets as support.

You record the estimate by crediting the allowance and debiting bad debt expense. That entry funds the reserve and puts the cost on the P&L in the same period as the related sales.

The allowance stays until a specific invoice is judged uncollectible. Then you debit the allowance and credit accounts receivable, which removes that invoice from the subledger.

That write-off does not hit expense again if the reserve was already there. Gross receivables and the allowance both fall, and the net asset stays the same.

If later experience is better or worse than the estimate, you adjust the allowance. Increasing it lowers net receivables and records more expense; decreasing it does the reverse.

Keep the reserve tied to support you can explain. A round number with no aging, no history, and no note is hard to defend at close.

Example

A catering company invoices a corporate picnic for $6,000, due in 30 days. From past corporate jobs, it expects about 5 percent of picnic invoices will never pay, so it records a $300 allowance.

Debit: Bad debt expense $300

Credit: Allowance for doubtful accounts $300

Gross receivables are $6,000, the allowance is $300, and net receivables are $5,700. Cash has not moved.

The Balance Sheet shows a smaller current asset than the invoice alone. The profit and loss statement shows $300 of bad debt expense in operating expenses.

Common mix-ups

The allowance is not cash sitting in a savings account. It is a book estimate that reduces receivables, not money you can spend.

The allowance is not the same as bad debt expense. The allowance is the Balance Sheet reserve; the expense is the P&L charge that funds or adjusts it.

Writing off an invoice is not the same as setting the reserve. The estimate credits the allowance; the later write-off uses that credit to clear a specific customer balance.

Related terms

• Accounts Receivable: Money customers owe the business for goods or services already delivered.
• Net Accounts Receivable: Gross receivables less the allowance for amounts not expected to be collected.
• Bad Debt Expense: The expense recorded when receivables are judged uncollectible.
• Accounts Receivable Aging: A report bucketing open invoices by how long they have been outstanding.
• Write-Off: Removing a balance from the books when it will not be collected or paid.
• Adjusting Journal Entry: An entry made at period end to record accruals, deferrals, and corrections.
• Materiality: The threshold at which an error or item is big enough to matter to a reader.
• Collections: The process of following up on unpaid customer invoices.