Allowance Method for Bad Debts (Step-by-Step Guide)

The allowance method for bad debts is an accounting approach that estimates uncollectible receivables at the end of each reporting period and records bad debt expense before any specific customer defaults. It is the method required by GAAP because it satisfies the matching principle — matching bad debt costs to the same period as the related credit sales revenue.

This guide walks through both estimation techniques, the complete journal entry sequence, and a worked example using XYZ Corp's accounts, so you can apply this method confidently in financial reporting and CPA exam scenarios.

What Is the Allowance Method?

The allowance method is a systematic way of accounting for bad debts by estimating uncollectible amounts at period-end and recording them through a contra-asset account called the Allowance for Doubtful Accounts. Unlike the direct write-off method, no specific customer needs to have defaulted for the expense to be recorded.

The core idea: if XYZ Corp has $120,000 in accounts receivable and knows from experience that 2% of credit sales go bad, it doesn't wait for customers to default. It estimates the bad debt expense — $10,000 — and adjusts the balance sheet now to reflect realistic net receivable values.

Why GAAP Requires the Allowance Method

The allowance method is preferred under Generally Accepted Accounting Principles (GAAP) for three main reasons:

1. Matching Principle

Revenue from credit sales is recognised when the sale occurs. The bad debt cost associated with those sales must be recognised in the same period. The allowance method achieves this; the direct write-off method does not.

2. Accurate Balance Sheet Presentation

By creating an allowance account, net accounts receivable reflects the amount the business actually expects to collect — not the gross amount billed. XYZ Corp's $120,000 A/R is presented as $110,000 net after a $10,000 allowance, which is more informative for investors and creditors.

3. Consistency and Comparability

Estimating bad debts every period creates a consistent expense pattern, making financial statements more comparable across reporting periods.

Percentage of Sales Approach

The percentage of sales method (also called the income statement approach) calculates bad debt expense as a fixed percentage of credit sales for the period. It focuses on the income statement — ensuring expense is matched to revenue — rather than targeting a specific allowance balance.

How It Works

1. Determine total credit sales for the period.
2. Apply the historical bad debt rate (derived from past collection experience).
3. Record the resulting amount as bad debt expense, regardless of the existing allowance balance.

Strengths and Limitations

Aging of Receivables Approach

The aging of receivables method (also called the balance sheet approach) targets a specific ending balance for the Allowance for Doubtful Accounts by grouping outstanding receivables into age brackets. Older balances are assigned higher default rates because they are statistically harder to collect.

XYZ Corp Aging Schedule

XYZ Corp's $120,000 in receivables at year-end breaks down as follows:

The aging method targets an ending allowance balance of $10,000. If the allowance already has a credit balance from prior periods, the adjusting entry is only the difference needed to reach $10,000.

Adjusting for Existing Allowance Balance

If the Allowance for Doubtful Accounts already has a $2,000 credit balance before the year-end adjustment:

Journal Entries — Step by Step

Three journal entries cover the complete allowance method lifecycle. For a deep dive with T-accounts and practice problems, see the Bad Debt Expense Journal Entry article.

Entry 1: Recognise Bad Debt Expense (Year-End Estimate)

Dr. Bad Debt Expense              $10,000
  Cr. Allowance for Doubtful Accounts   $10,000
(To record estimated uncollectible receivables — 2% × $500,000)

Entry 2: Write Off a Specific Account (Customer ABC — $3,000)

Customer ABC's invoice is 180+ days overdue and confirmed uncollectible:

Dr. Allowance for Doubtful Accounts   $3,000
  Cr. Accounts Receivable – Customer ABC   $3,000
(To write off uncollectible account — 180+ days overdue)

Entry 3: Recovery of a Previously Written-Off Account

If Customer ABC later pays the $3,000, two entries are required. Full treatment in: Bad Debt Recovery Journal Entry.

Step 1 — Reinstate the receivable:
Dr. Accounts Receivable – Customer ABC   $3,000
  Cr. Allowance for Doubtful Accounts       $3,000

Step 2 — Record the cash receipt:
Dr. Cash                              $3,000
  Cr. Accounts Receivable – Customer ABC   $3,000

Complete Example: XYZ Corp

Putting it all together for XYZ Corp's financial year:

Opening Facts

• Credit sales for the year: $500,000
• Accounts receivable at year-end: $120,000
• Existing allowance balance before adjustment: $0 (assume first year)
• Bad debt rate: 2% of credit sales
• Specific uncollectible: Customer ABC, $3,000, 180+ days overdue

Journal Entry Sequence

Year-End Balance Sheet Presentation

Note: After writing off Customer ABC's $3,000, gross A/R drops from $120,000 to $117,000 and the allowance drops from $10,000 to $7,000. Net A/R remains $110,000.

For full details on the Allowance for Doubtful Accounts, see: Allowance for Doubtful Accounts: Setup, Calculation & Entries.

Common Mistakes to Avoid

• Using total sales instead of credit sales in the percentage calculation — cash sales carry no receivable risk.
• Forgetting to adjust for the existing allowance balance under the aging method — you need only bring the balance to the target, not start from zero.
• Debiting bad debt expense for a write-off under the allowance method — the allowance account absorbs write-offs, not the income statement.
• Skipping the reinstatement step for recoveries — always reinstate the receivable before recording the cash receipt.

Back to the full overview: Bad Debt Expense: Complete Guide.

Frequently Asked Questions