As time passes, companies gain better information about which accounts might not be collected. They focus their estimates on major accounts that constitute most of their receivables. If a wholesale distributor finds that over a decade, about 3.2% of total AR typically becomes uncollectible, they might apply this percentage to their current receivables balance. Companies with a long operating history may rely on their long-term average of uncollectible accounts. This method is a bit more nuanced since it recognizes that the longer an invoice remains unpaid, the less likely it is to be collected—it’s not just applying a raw percentage to all credit sales.

This transaction doesn’t affect individual customer accounts—every customer still officially owes its full balance. The allowance for doubtful accounts might seem too subjective or imprecise for accounting, but it’s more accurate than pretending every invoice will be paid in full. Since a small percentage of customers often represent a large portion of receivables, some companies employ Pareto analysis (the 80/20 principle). Some companies take customer-specific factors into account by classifying customers into risk categories. Watch for dramatic changes in a company’s allowance for doubtful accounts in economic downturns.

Treasury Management

• Say your annual credit sales total $800,000, and 1.5% are expected to default.
• Without it, bad debt can blindside your finance team and leave you strapped for cash.
• A doubtful debt is an account receivable that might become a bad debt but it’s not certain if or when that will happen.

Industries with higher credit risk or volatility maintain a higher ADA accounting compared to those with lower risk. It safeguards against unexpected revenue shortfalls, protects the company’s financial stability, and accurately represents financial records. You should write off bad debt when it’s clear that a customer will not pay.

This method records bad debt only when a specific invoice is deemed uncollectible. The allowance method is required under GAAP, but the direct write-off method is common among small businesses that use cash accounting. Bad debt expense is the portion of accounts receivable that your company doesn’t expect to collect. When a customer fails to pay, you can write it off as a bad debt expense. However, as unpaid invoices begin building up, you can’t just let your bad debt accrue and skew the value of your accounts receivable.

Adjusting the Allowance

For example, a retail business analyzing five years of data might discover that about 2% of credit sales typically go unpaid. This method is simplest for businesses with stable customer payment patterns. Companies must choose a method that balances accuracy with being practical, considering their industry, customer base, and available data. Creating this allowance doesn’t require knowing exactly which customers will default.

Other companies use Provision for Doubtful Debts as the name for the current period’s expense that is reported on the company’s income statement. By estimating potential losses before they occur, companies present a more honest picture of their financial health while properly matching expenses to the periods when they earn revenue. Economic conditions change, customer payment patterns evolve, and the receivables balance fluctuates.

Recording journal entries and matching entries need not be manual in 2025.

Automated AR tools can help flag risky customers, track unpaid invoices, and streamline collections before debts become uncollectible. Refer to IRS guidance on bad debts, and consult a tax advisor to comply with your local regulations. Understanding how bad debt affects your taxes—and how to reduce future risk—can strengthen both your short-term cash flow and long-term financial strategy. It uses a contra account called allowance for doubtful accounts. The best choice depends on your business size, industry, and accounting system. Regularly recording bad debt helps you stay ahead of cash flow issues and build more accurate budgets and projections.

You would then apply this percentage to your actual sales in the current period to create your estimate. And when the funds for the sale are received, that debit shifts out of the A/R account. Other examples of contra-assets include accumulated depreciation, accumulated impairment losses, sales discounts, and sales returns. If your business was steady in the year prior and you do not anticipate significant changes to your business in the upcoming months, this is a simple and fast way to look at it. It helps you anticipate the possibility of late or partial payments, or even the risk of a customer declaring bankruptcy.

What is allowance for doubtful accounts?

The method involves a direct write-off to the receivables account. Sometimes, at the end of the fiscal period, when a company goes to prepare its financial statements, it needs to determine what portion of its receivables is collectible. Bad debt expense is typically classified as an operating expense on the income statement, alongside other costs related to running the business If you’re GAAP-compliant, use the allowance method. A write-off occurs when a specific account is deemed uncollectible and removed from the books.

This accounting practice not only provides a more accurate picture of a company’s financial health but also aligns with key accounting principles that govern financial reporting. When a business extends credit to customers, it’s taking a leap of faith. The allowance for doubtful accounts represents management’s estimate of how much of doubtful accounts and bad debt expenses accounts receivable will likely go uncollected. Bad debt expense also helps companies identify which customers default on payments more often than others. What if, instead of a credit balance in the allowance account, we posted a debit balance prior to the adjustment? Using the percentage of sales method, they estimated that 1% of their credit sales would be uncollectible.

It appears on the balance sheet as a contra-asset, directly reducing the accounts receivable (AR) balance to show a more conservative, realistic value of expected collections. Bad debt expense is something that must be recorded and accounted for every time a company prepares its financial statements. However, if there is already a credit balance existing in the allowance of doubtful accounts, then we only need to adjust it. It means, under this method, bad debt expense does not necessarily serve as a direct loss that goes against revenues.

Cash

Under the direct write-off method, bad debt expense serves as a direct loss from uncollectibles, which ultimately goes against revenues, lowering your net income. The portion that a company believes is uncollectible is what is called “bad debt expense.” Another common term used for bad debts is «doubtful accounts».

Balance Sheet

• Sometimes, at the end of the fiscal period, when a company goes to prepare its financial statements, it needs to determine what portion of its receivables is collectible.
• But how you record that loss affects your financial reporting, tax deductions, and cash flow.
• However, contrary to subtracting it, you actually incorporate it into your overall accounts receivable (AR).
• Then, a subsequent journal entry is made by debiting cash and crediting AR.

HighRadius helps accounting and finance teams simplify and accelerate the financial close and reporting process. Here is how a reliable collections automation solution can help optimize your collections and reduce the need to create an allowance for doubtful accounts. First, the company debits its AR and credits the allowance for doubtful Accounts.

Instead, it creates a pool of expected losses that sits on the balance sheet, reducing the overall reported value of AR from $1.5 million to $1.425 million. This works best when a company’s customer base and economic conditions stay relatively stable. This targeted approach can provide greater accuracy for businesses with clearly defined customer segments that have different payment behaviors. Companies apply a flat percentage to their credit sales for the period based on historical collection rates. Instead, companies use historical patterns, customer data, and economic trends to make estimates.

Second, it creates a contra asset account called «allowance for doubtful accounts» that reduces the reported value of AR without changing the underlying customer balances. First, it records a «bad debt expense» that reduces the current period’s profit. When a company sets up its allowance for doubtful accounts, it creates two simultaneous accounting entries. Accounting for potentially uncollectible accounts involves several distinct steps while creating a paper trail that tracks your expectations about customer payments and what actually happens when some customers don’t pay. An architectural firm with 50 clients might flag three accounts—a bankrupt developer, a chronically late-paying client, and a customer in a legal dispute—and set the allowance equal to their balances. When feasible, companies may review individual customer accounts to identify specific balances unlikely to be collected.

Specific Identification Method

Many of the functions and features we’ve already discussed can make life a lot easier for your customers. One rather effective strategy to repel bad debt is offering early payment discounts encouraging buyers to close out their invoices well before the initial due date. And with more accurate statements sent out, your customers will have fewer reasons to dispute invoice totals and delay payment.