Allowance for doubtful accounts

The allowance for doubtful accounts is a reserve on the balance sheet that reduces accounts receivable to its net realizable value — the amount the company actually expects to collect. When revenue is recognized under accrual-accounting, some customers inevitably fail to pay. Rather than waiting to know exactly which amounts will not be collected, accounting standards require companies to estimate the uncollectible percentage upfront and create a reserve. The difference between the allowance and what is actually uncollected is the bad-debt-expense on the income statement.

How the allowance works

The company carries accounts receivable at gross value, then deducts the allowance to show net receivable value. Example:

• Gross accounts receivable: $100 million
• Allowance for doubtful accounts: ($3 million)
• Net accounts receivable: $97 million

The $97 million is the amount the company expects to actually collect. The $3 million is expected to be uncollectible.

When a customer goes bankrupt and the company writes off its $200,000 invoice, the company does not take a new charge (it was already reserved). It simply removes the $200,000 from both gross receivables and the allowance.

Estimating the allowance

The company estimates the allowance using several approaches:

• Historical write-off rates: If the company has historically collected 97% of receivables, it might reserve 3%.
• Customer-specific analysis: For large customers, the company assesses credit quality individually.
• Aging analysis: Older receivables are riskier. A $500,000 invoice 90+ days past due is more likely to be uncollectible than one currently due.
• Economic outlook: During recession, default rates are higher. The allowance rises.

The estimate requires judgment and is a common area of earnings-management: conservative estimates inflate the allowance and reduce current income; aggressive estimates reduce the allowance and inflate income.

CECL and the shift in accounting

Until recently, companies used the incurred loss model: they only reserved for losses they believed had already occurred. Under CECL (Current Expected Credit Loss, effective 2020 for public companies), companies must reserve for losses they expect over the asset’s life, not just those that have occurred.

CECL is more forward-looking and conservative. During good times, companies must still reserve for expected future losses. During bad times, if there is reason to believe losses will improve, the allowance can decrease.

The shift to CECL significantly increased allowances for many companies and required major changes to systems and processes.

Impact on earnings quality

The allowance for doubtful accounts directly affects earnings quality. A company that:

• Underestimates the allowance: Reports higher income today but is at risk of larger write-offs and restatements later.
• Over-estimates the allowance: Reports lower income today but has a cushion for actual losses. More conservative.

Investors compare the allowance to the company’s own historical experience and to competitors. A sudden drop in allowance (without explanation) may signal aggressive accounting.

Disclosure in footnotes

Companies disclose the allowance methodology in footnotes, including:

• The balance of the allowance at period-end and prior year.
• The provision (charge to income) during the period.
• Write-offs and recoveries.
• The company’s policy for determining the allowance percentage.

A careful reading of these disclosures reveals how the company treats credit risk and whether policies are changing.

Relationship to bad debt expense

The bad-debt-expense on the income statement is the change in the allowance during the period (plus direct write-offs, if any). If the allowance grows from $2 million to $3 million, the expense is $1 million. This expense reduces net income.

Note: This is different from cash-basis-accounting, where bad debt expense only appears when the amount is actually written off.

See also