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Lesson 2 of 9Accounting for Assets
Unit 2 · Lesson 2 of 9

Estimating Bad Debts: The Allowance Method

The allowance method estimates uncollectible accounts in the same year as the sales that caused them, using either a percentage of credit sales or an aging of receivables that sets the allowance to a target balance.

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Key things to remember

  1. 1Year-end estimate: debit Bad Debts Expense, credit Allowance for Doubtful Accounts (a contra-asset with a normal credit balance).
  2. 2Percentage of sales: expense = rate × credit sales. Ignore the existing allowance balance.
  3. 3Aging or percentage of receivables: the estimate is the TARGET allowance balance. Adjustment = target − existing credit balance, or target + existing debit balance.
  4. 4Write-off: debit Allowance, credit Accounts Receivable. No expense, and NRV does not change.
  5. 5Recovery: reinstate (debit A/R, credit Allowance), then collect (debit Cash, credit A/R).
  6. 6Net realizable value = Accounts Receivable − Allowance for Doubtful Accounts.

Every business that sells on account knows that a few customers will never pay. It just does not know which ones yet. In BAF3M you used the direct write-off method: wait until a specific account is hopeless, then debit Bad Debts Expense and credit Accounts Receivable. That is simple, but it records the expense in the wrong year. A sale made in November 2026 might not be written off until June 2027. The 2026 income statement shows the revenue but none of its cost, and the 2026 balance sheet reports receivables the business will never collect. The allowance method fixes both problems by estimating the bad debts at year end, before anyone knows exactly which customers will default.

Matching and faithful representation
Bad debts are a cost of selling on credit, so they belong in the same period as the credit sales (the matching idea). Receivables should be reported at the amount the business actually expects to collect, its net realizable value. Canadian standards (ASPE and IFRS) expect this, so the direct write-off method is only acceptable when bad debts are too small to matter.

The Allowance for Doubtful Accounts

The estimate cannot be credited to Accounts Receivable, because no particular customer has defaulted and the control account must still equal the subsidiary ledger. Instead, the credit goes to Allowance for Doubtful Accounts, a contra-asset account. It sits right under Accounts Receivable on the balance sheet, has a normal credit balance, and is subtracted to show net realizable value (NRV): the amount the business expects to collect.

DateAccountDebitCredit
2026 Dec 31Bad Debts Expense$3,350.00
Allowance for Doubtful Accounts$3,350.00
The year-end adjusting entry. The amount comes from one of the two estimating approaches below.
Partial balance sheet, Dec 31, 2026
Accounts receivable$96,000.00
Less: Allowance for doubtful accounts$4,550.00
Net accounts receivable (NRV)$91,450.00
The allowance is subtracted from receivables to show the amount expected to be collected.
DrCrJournal entries(1) Dec 31, Year 1: estimateBad Debt Expense2 000Allowance for Doubtful Accts2 000Matches the expected loss to this year's sales.(2) Mar 5, Year 2: write off R. LeeAllowance for Doubtful Accts600Accounts Receivable600No expense now, and NRV does not change.(3a) Jun 10: Lee pays after all; reinstateAccounts Receivable600Allowance for Doubtful Accts600(3b) Jun 10: collectCash600Accounts Receivable600Reinstating first leaves a record that Lee paid.Accounts ReceivableDrCrBal Dec 3150 000(3a)600(2)600(3b)600Balance: 49 400 DrAllowance for Doubtful AccountsDrCr(2)600(1)2 000(3a)600Balance: 2 000 CrNet realizable value (NRV) = A/R − AllowanceAfter (1), Dec 31 Year 1:50 000 − 2 000 = 48 000After the write-off (2):49 400 − 1 400 = 48 000unchangedAfter the recovery (3a, 3b):49 400 − 2 000 = 47 400but Cash is up 600,so total assets are equal
Fig 1Estimate at year end into the allowance; later write-offs move specific accounts out of both receivables and the allowance.

Two ways to estimate: percentage of sales vs aging

APercentage of sales (income statement approach)
  • Bad Debts Expense = a percentage of the year's credit sales
  • The result IS the adjusting entry amount
  • Ignore any balance already in the allowance
  • Focuses on matching expense to revenue
BAging or percentage of receivables (balance sheet approach)
  • Estimate the uncollectible part of year-end receivables
  • The result is the TARGET balance of the allowance
  • Adjust for the balance already in the allowance
  • Focuses on reporting receivables at NRV

Percentage of sales: suppose Northshore made $420,000 of credit sales in 2026 and past experience says 1.5% of credit sales prove uncollectible. Bad Debts Expense is , and the entry is debit Bad Debts Expense $6,300, credit Allowance $6,300, no matter what the allowance already contains. If the allowance had a $1,200 credit balance before adjusting, it ends the year at $7,500.

Aging of receivables: list every customer balance by how long it is past due. The older a debt, the less likely it is to be collected, so each age group gets a higher estimated loss percentage. The total of the estimates is what the allowance SHOULD hold at year end. A simpler version, percentage of receivables, applies one rate to the whole balance (for example ); it is still a target balance.

Age of accountBalanceEstimated % uncollectibleEstimated uncollectible
Not yet due$60,0001%$600
1 to 30 days past due$20,0004%$800
31 to 60 days past due$9,00010%$900
61 to 90 days past due$5,00025%$1,250
Over 90 days past due$2,00050%$1,000
Total$96,000$4,550
Northshore Outfitters, aging schedule, December 31, 2026. The allowance should end the year with a $4,550 credit balance.
Age of accountBalance% uncollectibleEstimated uncollectible0–30 days60 0001%60031–60 days25 0004%1 00061–90 days10 00010%1 000Over 90 days5 00040%2 000Total100 0004 600Older accounts are less likely to be collected, so they get a higher percentage.The schedule gives the balance the Allowance should have: 4 600 CrAllowance already has a 1 100 credit balance:4 600 − 1 100 = 3 500If it had a 400 debit balance instead:4 600 + 400 = 5 000Bad Debt Expense3 500Allowance for Doubtful Accounts3 500Net realizable value = 100 000 − 4 600 = 95 400
Fig 2Older receivables get higher loss percentages; the column total is the target balance for the allowance.
The balance sheet approach adjusts TO a target
The $4,550 is NOT the journal entry. It is where the allowance must end up. If the allowance already has a $1,200 credit balance, add only . If it has a $700 debit balance (more was written off during the year than was estimated), you must first wipe out the debit and then build the credit: . Credit balance: subtract. Debit balance: add.
Quick checkTry it before you read on
1
An aging schedule estimates $6,000 of uncollectible accounts. Before adjusting, the allowance has a $900 debit balance. What is Bad Debts Expense for the year? Answer in whole dollars.
$
VideoBuilds an aging schedule and adjusts the Allowance for Doubtful Accounts to the target balance, the balance sheet approach from this lesson.Watch on YouTube

Write-offs, recoveries and net realizable value

When a specific account finally proves uncollectible, it is written off against the allowance: debit Allowance for Doubtful Accounts, credit Accounts Receivable (and the customer's subsidiary account). There is NO expense in this entry. The expense was already recognized when the estimate was made, and recording it again would count the same loss twice. Because the entry lowers both Accounts Receivable and the allowance by the same amount, net realizable value does not change.

DateAccountDebitCredit
2027 Feb 14Allowance for Doubtful Accounts$1,130.00
Accounts Receivable — T. Lam$1,130.00
May 20Accounts Receivable — T. Lam$1,130.00
Allowance for Doubtful Accounts$1,130.00
May 20Cash$1,130.00
Accounts Receivable — T. Lam$1,130.00
Feb 14: T. Lam's account is written off. May 20: T. Lam unexpectedly pays in full, so the account is reinstated and then collected.
Before write-offAfter write-off
Accounts receivable$96,000$94,870
Less: Allowance$4,550$3,420
Net realizable value$91,450$91,450
A write-off removes the same $1,130 from both lines, so net receivables do not change.

A recovery takes two entries. First reverse the write-off, which puts the debt back on the customer's account; this matters because the customer's record should show they did pay, which affects whether the business extends credit to them again. Then record the collection as a normal receipt on account. If only part of the debt is recovered, reinstate only the amount actually being collected.

Income Statement MethodBad Debts Expense = 1.5% × Net Salese.g. 1.5% × $100 000 = $1 500Balance Sheet Method (Aging Schedule)0-30 days4000× 2%8031-60 days1500× 5%7561-90 days800× 15%120over 90 days300× 40%120Allowance needed395Accounts Receivable6 600less: Allowance for Doubtful Accounts(395)Net Realizable Value6205
Fig 3Direct write-off versus the allowance method: when the expense is recorded and what the balance sheet shows.

Worked examples

Reveal one step at a time and try to beat it to the next line.

Example 1
Using Northshore's aging schedule (estimated uncollectible $4,550), the allowance has a $1,200 credit balance before adjustment on December 31, 2026. Accounts Receivable is $96,000. Journalize the adjustment and find NRV.
Example 2
Same aging schedule (target $4,550), but this time the allowance has a $700 DEBIT balance before adjustment, because write-offs during the year exceeded the previous estimate. Journalize the adjustment.
Example 3
A different company uses percentage of sales. Credit sales were $350,000 and 2% are expected to be uncollectible. The allowance has an $850 credit balance before adjustment. Find the expense and the allowance's ending balance.
Example 4
On March 3, 2027, a company with A/R $50,000 and an allowance of $2,500 writes off K. Osei's $800 account. On July 15, K. Osei pays $500 and says no more will come. Journalize, and show NRV before and after the write-off.

Where marks get lost

  • Using the aging total as the journal entry amount. With the balance sheet approach, the total is the target balance; adjust for what is already in the allowance.
  • Subtracting a debit balance instead of adding it. A debit balance must be cleared first, so it is added to the target.
  • Adjusting for the existing balance under percentage of sales. That approach computes the expense directly; the existing balance is ignored.
  • Debiting Bad Debts Expense when an account is written off under the allowance method. The expense was recorded with the estimate; the write-off is debit Allowance, credit A/R.
  • Thinking a write-off lowers net receivables. It lowers A/R and the allowance by the same amount, so NRV is unchanged.

Flashcards 7

Allowance for Doubtful Accounts
Net realizable value of receivables
Percentage of sales approach
Aging approach
+ 3 more

Practice

1
An aging schedule estimates uncollectible accounts of $8,200. The allowance has a $1,750 credit balance before adjustment. What is the adjusting entry amount? Answer in whole dollars.
$
2
Credit sales are $620,000 and 1.25% are expected to be uncollectible. The allowance has a $400 debit balance before adjustment. Using percentage of sales, what is Bad Debts Expense? Answer in whole dollars.
$
3
Accounts Receivable is $75,000. The aging target is $3,900 and the allowance had a $600 debit balance before adjustment. After adjusting, what is net realizable value? Answer in whole dollars.
$
4
Under the allowance method, writing off a $2,000 account has what effect?
5
Which method best follows the matching idea?
6
A customer whose account was written off last year pays in full. Put the entries in order.
  1. 1Debit Cash, credit Accounts Receivable
  2. 2Debit Accounts Receivable, credit Allowance for Doubtful Accounts
  3. 3Post both entries to the customer's subsidiary account
7
Match each situation to the correct entry.
Year-end estimate
Write-off of a specific account
Reinstating a recovered account
Direct write-off method
8
An aging schedule shows: not due $40,000 at 2%; 1 to 60 days $12,000 at 10%; over 60 days $3,000 at 40%. What is the target allowance balance? Answer in whole dollars.
$
9
What type of account is Allowance for Doubtful Accounts?

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