The allowance method for bad debts records an estimated loss against your accounts receivable in the same period you booked the sale, rather than waiting for a specific customer to default. You do it with two kinds of journal entries: a period-end adjusting entry that builds a reserve, and a write-off entry that draws against that reserve when an individual account actually goes bad. Generally Accepted Accounting Principles require this approach whenever uncollectible amounts are material.
The Two Entries That Do the Work
The allowance method runs on a contra-asset account called Allowance for Doubtful Accounts. It sits alongside Accounts Receivable on the balance sheet and reduces it. Gross receivables minus the allowance equals Net Realizable Value, the amount you actually expect to collect.
At the end of each reporting period, you record the adjusting entry that recognizes expected losses:
- Debit Bad Debt Expense (income statement)
- Credit Allowance for Doubtful Accounts (balance sheet)
That single entry is what makes the method work. The expense hits the same period as the revenue that produced the risky receivable, so your reported profit already reflects the losses you expect to absorb.
When collection efforts on a specific customer fail, the customer files bankruptcy, or the statute of limitations runs out, you write the account off:
- Debit Allowance for Doubtful Accounts
- Credit Accounts Receivable
Bad Debt Expense is not in that entry. The expense was already recognized when you built the allowance; the write-off just spends the reserve. Gross receivables and the allowance both drop by the same amount, so Net Realizable Value is unchanged.
Sizing the Allowance
How large the adjusting entry should be depends on how you estimate future losses. Two traditional approaches dominate, and they come at the answer from opposite directions.
Percentage of Sales
Start with net credit sales for the period and apply a historical loss rate. If experience says 1.5 percent of credit sales eventually go unpaid and this quarter’s credit sales were $800,000, you record $12,000 of bad debt expense and credit the allowance for the same amount. You do this regardless of what balance is already sitting in the allowance.
The method is simple and gives a consistent expense that tracks with revenue. Its weakness is drift: over several periods the allowance balance can wander above or below the level your receivables actually justify, so it needs to be checked against the receivables from time to time.
Aging of Receivables
The aging approach works backward from the balance sheet. Sort every open invoice into buckets by how far past due it is (current, 1–30 days, 31–60, 61–90, over 90), and assign each bucket a 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 by its rate, add the results, and that total is the ending balance the allowance should have.
Here the existing allowance balance matters. If your target is $18,000 and the allowance already has a $2,000 credit balance, the adjusting entry is $16,000. If write-offs had pushed the allowance to a $1,000 debit balance, you would need a $19,000 entry to reach $18,000.
Aging tends to produce a more precise reserve because it reflects the actual composition of your receivables at the reporting date. Auditors generally prefer it for that reason.
Recording a Recovery
Sometimes a customer whose account you wrote off pays after all. A recovery takes two entries because you need to put the receivable back on the books before you can apply cash to it.
First, reverse the write-off. Debit Accounts Receivable and credit Allowance for Doubtful Accounts. This restores the customer’s balance and rebuilds the allowance by the same amount.
Then record the payment. Debit Cash and credit Accounts Receivable. Bad Debt Expense is not touched in either step. Reinstating the receivable also restores the customer’s payment history in your records, which matters if you extend credit to them again.
What CECL Changed About the Estimate
The mechanics above are unchanged, but what feeds the loss rate is not. In 2016 the Financial Accounting Standards Board issued ASC 326, the Current Expected Credit Loss standard. Public companies adopted it in 2020, private companies in 2023.
CECL requires you to estimate expected credit losses over the remaining life of the receivable, not just losses you think have already been incurred. The estimate must combine three layers of information: historical loss experience, current conditions, and reasonable and supportable forecasts about 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 The forecast layer is the change: if your industry is heading into a downturn and customer credit is deteriorating, the allowance has to reflect that even when historical write-offs have been low.
The standard does not prescribe a single calculation. An aging schedule, a loss-rate approach, a probability-of-default model, a discounted cash flow analysis, or some combination can all satisfy it, as long as the inputs reflect lifetime expected losses adjusted for forecasted conditions. For periods beyond which you can make a reasonable 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 businesses are not exempt if they follow U.S. GAAP, but regulators expect the standard to be scalable. A community bank or small manufacturer does not need an econometric model; adjusting existing aging percentages for observable economic trends can be enough.2Federal Reserve Board. Frequently Asked Questions on the New Accounting Standard on Financial Instruments – Credit Losses
The Tax Return Does Not Follow the Books
The allowance method is a financial reporting method. The IRS does not accept it. 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 Your tax return uses the direct write-off method even while your books use the allowance method.
Proving a debt is worthless requires evidence, not an estimate. The IRS looks at whether the debtor went through bankruptcy, abandoned the business, repeatedly refused to respond to collection attempts, or has no assets to seize, and it expects to see that you took reasonable steps to collect.4Internal Revenue Service. Topic No. 453, Bad Debt Deduction No single factor decides the question; worthlessness is judged on the totality of the circumstances.5Internal Revenue Service. Section 166 – Deduction for Bad Debts
Because you book the expense before the IRS lets you deduct it, book income and taxable income diverge in the year of the estimate. That difference shows up 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 It also produces a deferred tax asset that unwinds in the later period when the specific debt qualifies for deduction.
Revising the Estimate
Your loss rates will shift over time. Customer mix changes, economic conditions change, collection practices change. When you revise the percentage or the methodology, GAAP treats the revision as a change in accounting estimate. You apply it prospectively, which means the effect goes into the current period and forward. Prior financial statements are not restated.
If aging analysis shows the 61–90 day bucket now defaults at 25 percent instead of the 15 percent you used last year, you raise the allowance this period at the new rate. Prior periods were reported on the best information available then, and rewriting them would create more confusion than accuracy.
When the Direct Write-Off Method Is Allowed
The direct write-off method skips estimation entirely: no expense is recorded until a specific customer defaults, at which point Bad Debt Expense is debited and Accounts Receivable is credited. The problem is timing. A sale in December might not produce a write-off until the following August, which overstates income in the first year and understates it in the second. GAAP permits direct write-off only when uncollectible amounts are so small relative to revenue that the distortion is immaterial. Most businesses run both systems in parallel: the allowance method on the books, direct write-off on the return.