Allowance for Doubtful Accounts: What It Is and How to Calculate It

The allowance for doubtful accounts is the accounting recognition that part of what sits in receivables will not arrive. It is not pessimism: it is how a company's results reflect the reality of the book before the loss is confirmed.

A business that sells on terms without reserving records profit that does not exist yet — and then takes the loss all at once, months later, in a quarter that had nothing to do with the decision that caused it.

Why reserve at all

• Puts the real cost of credit in the period that generated it
• Avoids distortion between strong sales months and loss recognition months
• Gives a basis for pricing: if expected loss is 2%, margin has to absorb 2%
• Creates discipline around tracking the past-due book

Method 1: percentage by aging bucket

The most common approach in commercial companies because it is simple and auditable:

Do not copy the percentages: derive them from your own history. The question to answer with 24 months of data is direct — of everything that reached 60 days past due, how much actually became a loss?

Method 2: expected credit loss

More precise and closer to current accounting standards, which require an expected-loss view rather than waiting for a loss to become probable:

Expected loss = probability of default × exposure × loss given default

Applied by risk tier rather than by aging bucket, which also reserves against the current book according to who owes it. It requires a calibrated score and recovery history — inputs that come from vintage analysis.

Reserve versus write-off

They are different and both need tracking:

• The allowance is an estimate; it reduces results when established
• The write-off recognizes that a specific balance will not be collected

When the allowance is well calibrated, actual write-offs in a period land close to what was reserved for that group. A reserve consistently above realized loss understates results; one below it defers the loss.

When to write off

Write-off follows tax rules and internal policy. Common criteria:

• Administrative collection efforts exhausted
• Legal cost above the recoverable amount
• Customer in bankruptcy with no expected distribution
• A defined period with no payment at all

A write-off does not mean abandoning collection. The claim still exists legally and can be settled later — including through a payment plan.

Effect on pricing

The allowance is the cost of credit and belongs in the price of selling on terms, alongside the financing cost of the days granted. An operation reserving 2.5% and passing none of it into price is funding bad debt out of its own margin.

Common mistakes

• Reserving only what is past due. The current book of higher-risk customers also carries expected loss.
• Using reference percentages without calibration. The yardstick has to come from your history.
• Releasing reserves to improve a month. Distorts the number and delays the decision.
• Not separating restructured balances. A restructured invoice carries more risk and deserves its own bucket.

What to take from this

Reserve by buckets calibrated on your own history, track reserve and realized loss side by side, and revisit the percentages annually. And carry the cost into the price of selling on terms — it does not disappear by going uncalculated.