What is the Allowance for Bad Debts?

The allowance for bad debts is a reserve against the amount of accounts receivable that customers may not pay. When actual bad debts are recognized, they are charged against this allowance account. By using an allowance for bad debts, a business can charge off the incremental expected change in bad debts as soon as receivables are recorded. This approach tends to result in the more rapid recognition of bad debts, rather than waiting for specific bad debts to be identified, which may be several months later. The use of an allowance also tends to result in the recognition of a more consistent amount of bad debt expense from period to period. This allowance approach is required under the accrual basis of accounting, so that all expenses associated with a sale transaction are recorded in the same reporting period as the sale.

Example of the Allowance for Bad Debts

The historical bad debt percentage of Sunrise Solutions is 1% of sales. In its most recent month the company sells $1,000,000 on credit, so it debits bad debt expense for $10,000 (calculated as 1% of the total) and credits the allowance for bad debts for $10,000. In the following month, one of the firm’s billings (for $3,000) is identified as not collectible. Accordingly, the accounting department processes a credit memo against the invoice, crediting receivables for $3,000 and debiting the allowance for bad debts.