The allowance method for bad debts, step by step

When a business sells on credit, some customers will never pay. The allowance method records that cost in the same period as the sales that caused it, before anyone knows exactly which customers will default. This page explains how the method works, shows the two common ways to estimate the expense, walks through a write-off, and covers the mistakes that trip up most beginners.

Why bad debts need an estimate

Selling on account creates a receivable: the customer takes the goods or services now and pays later. Most customers pay. A few do not, because they close, dispute the bill or simply disappear. The amount a business fails to collect is a real cost of selling on credit, and it is called bad debt expense.

The difficulty is timing. A sale made in November might turn out to be uncollectible next June. If the business waited until June to record the expense, the cost would land in a different period from the revenue it belongs to. The allowance method solves this by estimating, at the end of each period, how much of this period's credit activity will not be collected, and recording that estimate as an expense right away.

Because nobody knows yet which specific customers will fail to pay, the estimate cannot be taken out of any one customer's account. Instead it goes into a separate account called Allowance for Doubtful Accounts.

The allowance account

Allowance for Doubtful Accounts is a contra asset. "Contra" means it sits next to an asset and reduces it. It has a normal credit balance, while Accounts Receivable has a normal debit balance. On the balance sheet the two are shown together:

This keeps the full list of customer balances intact while still showing a realistic figure for what the business expects to collect.

The two entries of the allowance method

The method has two separate entries at two separate times:

1. The adjusting entry, at the end of each period: debit Bad Debt Expense, credit Allowance for Doubtful Accounts. This records the estimated cost.
2. The write-off, whenever a specific account is confirmed as uncollectible: debit Allowance for Doubtful Accounts, credit Accounts Receivable. This removes that customer's balance.

The expense is recorded once, in the first entry. The write-off does not touch expense at all. It uses up part of the allowance that was set aside earlier.

Estimating the expense: two approaches

The size of the adjusting entry depends on the estimating method. There are two common approaches, and they work in different ways.

Percent of credit sales

This approach looks at the income statement. It asks: "Of this period's credit sales, how much will we fail to collect?" Multiply credit sales by an expected loss rate, and the result is the expense. The existing balance in the allowance plays no part.

Aging of receivables

This approach looks at the balance sheet. It groups the customer balances by how long they have been outstanding, applies a higher expected loss rate to older groups, and adds up the results. That total is the balance the allowance should have at the end of the period. The entry is whatever amount brings the allowance from its current balance to that target.

Worked example 1: percent of credit sales

Copperleaf Studio had $206,800.00 of credit sales this year. Using an example rate, it estimates that 2.5% of credit sales will never be collected. Before adjusting, Allowance for Doubtful Accounts has a $1,210.00 credit balance.

Under the percent-of-sales approach, the expense is simply:

$206,800.00 × 2.5% = $5,170.00

The $1,210.00 existing balance is a distraction here. After the entry, the allowance holds $6,380.00, and that is fine: this method targets the expense, not the ending allowance.

Worked example 2: aging with an existing credit balance

Northside Print Shop ages its receivables using these example rates:

Before adjusting, the allowance already has a $675.00 credit balance. The target is $1,462.70, so the entry only needs to add the difference:

$1,462.70 − $675.00 = $787.70

After posting, the allowance is $675.00 + $787.70 = $1,462.70, exactly the aging estimate.

When the allowance has a debit balance

Sometimes write-offs during the year are larger than the amount set aside, and the allowance ends up with a debit balance before the adjustment. In another Northside Print Shop example, the aging target is $1,782.20 and the allowance starts with a $1,640.00 debit balance. The allowance is below zero, so the entry must first climb back to zero and then reach the target:

$1,782.20 + $1,640.00 = $3,422.20

Debit Bad Debt Expense and credit the allowance for $3,422.20. Afterwards the allowance shows a $1,782.20 credit balance.

Worked example 3: writing off an account

Juniper Landscaping uses the allowance method. A customer, R. Patel, has closed and will not pay the $2,280.56 it owes. The business now knows exactly which account has failed, so it removes that balance:

Net receivables do not change. Accounts Receivable goes down by $2,280.56 and the allowance goes down by the same amount, so the difference between them stays the same. That makes sense: the loss was already expected and already expensed.

Common mistakes and how to avoid them

Each mistake below is one that our exercises catch and explain.

Using the allowance balance with percent of sales

Subtracting the existing balance belongs to the aging approach, not the percent-of-sales approach. In the Copperleaf example, subtracting $1,210.00 gives $3,960.00 instead of $5,170.00. With percent of sales, record credit sales times the rate and ignore the existing balance.

Crediting Accounts Receivable in the adjusting entry

At the end of the period you do not know which customers will default, so you cannot reduce any customer's balance. Credit the contra account, Allowance for Doubtful Accounts.

Debiting Bad Debt Expense on a write-off

This records the same loss twice: once when it was estimated and again when it happens. Under the allowance method the write-off debits the allowance instead.

Crediting the allowance on a write-off

A write-off uses up the allowance, so the allowance is debited. The customer's balance disappears, so Accounts Receivable is credited.

Recording the whole aging estimate

The aging total is the ending balance you want, not the size of the entry. Recording all $1,462.70 when $675.00 is already there would leave the allowance at $2,137.70. Record only the difference.

Getting the direction of the existing balance wrong

With a credit balance, subtract it from the target. Adding it, as in $1,462.70 + $675.00 = $2,137.70, overshoots. With a debit balance, add it. Subtracting it, as in $1,782.20 − $1,640.00 = $142.20, leaves the allowance far short.

Choosing between the two approaches

Both approaches are part of the allowance method, and both produce the same kind of entry. They differ in what they measure, so they suit different goals.

Percent of credit sales is quick. It needs one figure from the income statement and one rate. Because the expense is tied directly to the period's sales, it gives a clean match between revenue and the cost of selling on credit. Its weakness is that the allowance balance can drift over the years, since nothing checks it against the receivables actually outstanding.

Aging of receivables takes more work, because someone must sort every customer balance by age. In return, it gives a better picture of the balance sheet: the allowance reflects the actual receivables on hand, and older, riskier balances carry more weight. Its weakness is that the expense becomes a plug, the amount needed to reach the target, so it can swing from year to year.

Some businesses use percent of sales during the year for monthly statements and run an aging at year end to check the allowance. Whichever approach a question names, follow that approach's rule about the existing balance.

A quick routine for any bad debt question

1. Decide which entry is needed: an estimate at period end, or a write-off of a specific account.
2. For a write-off, debit the allowance and credit Accounts Receivable for the customer's balance. You are done.
3. For an estimate, identify the approach. Percent of sales: the expense is credit sales times the rate. Aging: the target is the sum of each age group times its rate.
4. With aging, compare the target with the current allowance. Subtract a credit balance; add a debit balance.
5. Debit Bad Debt Expense and credit the allowance, then check that the new allowance balance makes sense.