How to Use an Allowance for Doubtful Accounts

Any company with a large number of customers can count on some of them not paying for the goods they receive. The allowance for doubtful accounts, sometimes called an allowance for bad debts or reserve for bad debts, is a balance sheet item that reflects this reality by adjusting downward the value of accounts receivable.

Using an allowance for doubtful accounts helps you get a timelier and more realistic picture of how much of your accounts receivable will actually turn into cash. Without it you could unexpectedly run out of money to fund operations because you were counting on every last dime of your accounts receivable coming in.

An allowance for doubtful accounts also helps companies that use the accrual basis for accounting to avoid having to adjust earnings downward in the event that some reported revenue turns out to be uncollectible. Since those are just the surprises that lenders and investors as well as entrepreneurs tend to dislike, having an allowance for doubtful accounts is a good idea. Essentially, it can help anybody who is using your financial reports to draw a more reliable picture of your financial status and performance.

Here’s a simple two-step method to estimate your allowance for doubtful accounts: First take the amount you had to write off last year and divide it by the total of all credit sales you had during that year. Next multiply the resulting percentage by the amount of credit sales you have during the current reporting period.

For example, assume you had $1 million in total credit sales last year and wrote off $15,000 as uncollectible bad debt. Dividing 15,000 by 1 million gives you 0.015, or 1.5 percent. Assume you expect $275,000 in total credit sales during the current quarter. Multiplying 275,000 by 1.5 percent produces 4,125. That makes $4,125 your allowance for doubtful accounts during the current quarter.

Your allowance for doubtful accounts on the balance sheet interacts with the entry for bad debt expense on your income statement. When you find out an account can’t pay, that increases the amount of bad debt expense on your income statement. And when you increase bad debt expense, you should credit that amount to the allowance for doubtful accounts.

Both the allowance for doubtful accounts and the bad debt expense entries can be considered good faith estimates as opposed to hard-and-fast numbers. If a customer is unable to pay because of bankruptcy, for instance, you’ll often be able to eventually collect at least a portion of the debt. The estimates are valuable, however, because they help you as well as others to avoid counting on money that isn’t likely to come in.

The amount you actually put down for an allowance for doubtful accounts represents a cushion against unpleasant surprises. In that sense, the higher the amount, the more conservatively you could be said to manage your business.

While an allowance for doubtful accounts can help you produce more accurate, timely, and useful financial reports, it can’t help you at tax time. The IRS only allows you to include an account as a bad debt expense to be deducted from income after you’ve actually written it off as uncollectible at the end of the year.

Mark Henricks writes about business, technology, personal finance, and other topics from Austin, Texas. His work has appeared in The Wall Street Journal, Entrepreneur magazine, The Washington Post, and other leading publications.