What is the Allowance Method for Bad Debts?

The Allowance Method for Doubtful or Uncollectible Accounts is used to estimate future bad debts based on current month revenues. Using past performance data, a company can estimate that a certain percentage of current sales can reasonably expect to become bad debts. To conform to the Matching Principle, the company records that potential bad debt in the same month that the related revenue is recorded.

Why is the Allowance Method Used?

At the time revenue is recorded, a company does not yet know which accounts will prove to be uncollectible. We don’t want to record any reduction in the Accounts Receivable account so we use a related contra account called Allowance for Doubtful Accounts or Allowance for Uncollectible Accounts to track the estimate. By using the contra account, we can preserve the true Accounts Receivable balance while also recognizing that some portion of that balance is overvalued because of potential bad debt.

On the Balance Sheet here is how that is reported:

Accounts Receivable$10,000
Less Allowance for Doubtful Accounts (500)
Net Realizable Value$ 9,500
Table showing Accounts Receivable portion of a Balance Sheet

What we are showing on the Balance Sheet is the full value of Accounts Receivable and the realistic value of what we expect to collect of that amount. This ties in to the GAAP rule of Conservatism–accurately representing the value of accounts including potential losses on the financial statements.

How Do You Write-off Bad Debt Using the Allowance Method?

Because the Allowance for Doubtful Accounts is based on an estimated amount, a company chooses a method to use in making that estimate. The two most common methods taught in accounting classes are:

  1. Aging of Accounts Receivable Method
  2. Percent of Sales Method

The Aging of Accounts Receivable Method focuses on the Balance Sheet (Assets). The Percent of Sales Method focuses on the Income Statement (Revenue). Either method conforms to GAAP.

Caroline Grimm

Caroline Grimm is an accounting educator and a small business enthusiast. She holds Masters and Bachelor degrees in Business Administration. She is the author of 11 books and the creator of Accounting How To YouTube channel and blog. For more information visit: https://accountinghowto.com/about/

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