Receivables and the Allowance for Doubtful Accounts

A company sells $1 million of goods on credit this quarter. History says roughly 2% of any batch of receivables like this never gets collected — customers go bankrupt, disputes drag on, invoices get written off. Waiting until each customer actually defaults to record the loss would mean overstating assets and profit for months or years in between. Instead, accounting rules require the company to estimate the expected loss now and set up a reserve against it, so the balance sheet shows what the receivables are actually worth, not just their face value.

How the reserve moves

Two entries drive the account. First, the company estimates expected losses and books bad debt expense, which increases the allowance:

$$\text{Ending allowance} = \text{Beginning allowance} + \text{Bad debt expense} - \text{Write-offs}$$

In words: the reserve grows every period by however much new expected loss is estimated, and shrinks whenever a specific receivable is finally declared uncollectible and removed. A write-off doesn't create a new expense — the expense was already taken when the reserve was built; the write-off just uses up reserve that's already there.

Worked example

A company starts the year with a $50,000 allowance. During the year it writes off $30,000 of specific invoices it now knows are uncollectible, and based on aging its current $2 million receivables book, it estimates it needs a $55,000 allowance at year-end.

1. Reserve after write-offs, before new estimate: $50{,}000 - 30{,}000 = 20{,}000$, i.e. $20,000.
2. Additional bad debt expense needed to bring the reserve up to the new $55,000 target: $55{,}000 - 20{,}000 = 35{,}000$, i.e. $35,000.
3. This $35,000 flows through the income statement as bad debt expense this year, even though it relates to invoices that haven't defaulted yet — it's the expected loss on the whole $2 million pool, estimated using historical write-off rates and current aging.

What this means in practice

Analysts watch the allowance as a percentage of gross receivables over time — a shrinking ratio while receivables growth outpaces revenue growth can mean management is under-reserving to protect earnings, deferring a bad-debt hit to a future quarter. Comparing that ratio to accounts receivable aging (how much is 90+ days overdue) is a quick sanity check on whether the reserve looks adequate.