Allowance for doubtful accounts: Definition, methods, and calculations

An allowance for doubtful accounts is an estimate of the payments you don’t expect to collect from invoices you’ve already sent to customers. Setting up an allowance gives you a more accurate view of your company’s financial health. It helps you manage bills and make decisions based on the income you can reasonably expect to receive, instead of using inflated figures that assume every customer will pay in full.

Late payment and nonpayment are important issues for companies. The 2025 QuickBooks Late Payments Report found that unpaid invoices affect 56% of small businesses, with customers owing the average company $17,500. Worse still, Atradius found that bad debts—invoices that customers never pay—account for 9% of all B2B sales.

In this article, you’ll learn what allowances for doubtful accounts are, how to estimate bad debt, and how to record it accurately in your books.

Understanding allowance for doubtful accounts

Methods for estimating allowance for doubtful accounts

How do you record allowance for doubtful accounts

Allowance for doubtful accounts benchmarks

Streamline your accounting and save time

Understanding allowance for doubtful accounts

An allowance for doubtful accounts is a “contra asset,” not a typical asset. A contra asset account offsets the balance of a related asset on your balance sheet. In plain terms, it’s like having a “minus” column that you pair with your customer invoices.

The benefits of using an allowance for doubtful accounts are: 

• A truer financial overview: By adjusting your accounts receivable to reflect what you expect to collect, you get a more accurate picture of your financial health.
• More informed planning: You set your company budget on expected cash inflows instead of assuming all invoices will be paid in full.
• Reliable financial reporting: Sudden, large write-offs can make your business look financially unstable, especially to lenders and investors. An allowance for doubtful accounts smooths out these impacts and presents more accurate, realistic figures over time.

One way to estimate your allowance for doubtful accounts is by calculating your average bad debt percentage. To do that, look at your financial records from the last 12 months and use this simple formula:

(Total amount of bad debt written off ÷ Total credit sales) x 100

You can then use that percentage in two ways. 

First, use the percentage to “mark down” your income each month for planning purposes. If your bad debt percentage is 5% and your monthly revenue is $100,000, base your budget on $95,000 instead.

Second, mark up your prices to cover this shortfall. To offset a 5% bad debt rate, you need to increase your prices slightly to make up for the missing cash. Here’s the calculation using the 5% bad debt as an example:

• Subtract your bad debt percentage from 100 (100 - 5 = 95)
• Divide the bad debt percentage by that answer (5 ÷ 95 ≈ 0.053)
• Multiply by 100 to get your mark-up (0.053 x 100 = 5.3%)

Adding this 5.3% to your prices means you can still hit your target profit margin after accounting for the predictable cost of future bad debts.

GAAP requirements for the allowance for doubtful accounts

The Generally Accepted Accounting Principles (GAAP) require companies to use an allowance for doubtful accounts as part of their financial reporting. This ties into the “matching principle,” which states you recognize expenses in the same period as the revenue they helped generate. 

In the case of bad debt, this means estimating expected losses when you make the sale, not when an invoice goes unpaid. The purpose of the rule is to treat bad debts as normal operating costs.

Debit vs. credit in the allowance for doubtful accounts

An allowance for doubtful accounts is both a debit and a credit. You credit the allowance to record your estimate for bad debts and debit it to write off a specific invoice.

Here's how the entries work in each case:

• Credit entries: Estimate how much of your new sales you don’t expect to collect within an accounting period. If that’s $500, you’d credit your allowance for doubtful accounts and debit your bad debt expense balance for that sum.
• Debit entries: When you know you won’t be able to collect an invoice and want to write it off in accounts, you debit your allowance for doubtful accounts and credit your accounts receivable balance by the amount of the invoice.

Methods for estimating allowance for doubtful accounts

The allowance for doubtful accounts (ADA), aka bad debt reserves, is a contra asset account that sits under your accounts receivable account on the balance sheet. It always has a credit balance and shows how much you estimate you won’t be able to collect. When you write off a specific invoice, you reduce the allowance (debit ADA) and accounts receivable (credit AR).

If you use the accrual basis of accounting, you will record doubtful accounts in the same accounting period as the original credit sale. This presents a more realistic picture of the accounts receivable amounts you expect to collect versus what goes under the allowance for doubtful accounts.

There are five key methods for estimating uncollectible accounts. Let’s look at how to calculate allowance for doubtful accounts and how it can provide a more accurate picture of a company's financial position: 

Percentage of sales method

Best for: A quick and simple way of estimating bad debt, useful for companies with high sales volumes

The percentage of sales method assigns a flat rate to each accounting period’s total sales. Using previous invoicing data, your accounting team can then estimate what percentage of credit sales will be uncollectible. 

For example, let’s say a jewelry store earns $100,000 in net sales, but it estimates that 4% of the invoices will be uncollectible. The company’s allowance for doubtful accounts is $4,000. 

Accounts receivable aging method 

Best for: Companies that invoice before receiving payment

The accounts receivable aging method uses accounts receivable aging reports to monitor past due invoices. Using historical data from an aging schedule can help you predict whether or not you’ll receive an invoice payment.

For example, the jewelry store assumes 25% of invoices that are 90 days past due are considered uncollectible (so it assumes that 75% of the invoices in this age group will be paid). Say it has $10,000 in unpaid invoices that are 90 days past due—its allowance for doubtful accounts for those invoices would be $2,500, or $10,000 x 25%.

Risk classification method

Best for: Businesses that serve customers with a mix of different levels of credit risks, like brand-new companies and larger, established companies

The risk classification method involves assigning a risk score or risk category to each customer based on specific criteria, such as payment history, credit score, and industry. The company then uses the historical percentage of uncollectible accounts for each risk category to estimate the allowance for doubtful accounts.

To use the risk classification method:

1. Assign a risk score or category to each customer.
2. Determine the historical percentage of uncollectible accounts for each category.
3. Multiply the accounts receivable amount for each category by the historical percentage.
4. Add up the estimated allowances for each category.

For example, our jewelry store may assign a customer a risk category of C. That category has a historical percentage of uncollectible accounts of 10%. The customer has $5,000 in unpaid invoices, so its allowance for doubtful accounts is $500, or $5,000 x 10%.

Pareto analysis method

Best for: Companies with a small but identifiable group of clients who cause most of the payment issues 

The Pareto analysis method relies on the Pareto principle, which states that 20% of the customers cause 80% of the payment problems. By analyzing each customer’s payment history, businesses allocate an appropriate risk score, categorizing each customer into a high-risk or low-risk group. Once the categorization is complete, businesses can estimate each group's historical bad debt percentage. 

For example, our jewelry store has 1,000 customers:

• We determine 200 customers are high-risk and 800 are low-risk.
• The historical bad debt percentage for the high-risk group is 5% and 1% for the low-risk group. 
• The outstanding balance for the high-risk group is $500,000, and $1,500,000 for the low-risk group.

As a result, the estimated allowance for doubtful accounts for the high-risk group is $25,000 ($500,000 x 5%), while it’s $15,000 ($1,500,000 x 1%) for the low-risk group. Thus, the total allowance for doubtful accounts is $40,000 ($25,000 + $15,000). 

Specific identification method

Best for: Businesses selling high-value items to a small number of customers, where each sale is large enough to warrant individual customer review

The specific identification method allows a company to pick specific customers that it expects not to pay. In this case, our jewelry store would use its judgment to assess which accounts might go uncollected. 

For example, it has 100 customers, but after assessing its aging report decides that 10 will go uncollected. The balance for those accounts is $4,000, which it records as an allowance for doubtful accounts on the balance sheet. 

How do you record allowance for doubtful accounts?

When a business makes credit sales, there’s a chance that some of its customers won’t pay their bills, resulting in uncollectible debts. To account for this possibility, businesses create an allowance for doubtful accounts, which serves as a reserve to cover potential losses. 

Creating this allowance ensures that the financial statements reflect a more accurate picture of the company's financial position and performance. The allowance provides a cushion against potential losses arising from bad debts, which may otherwise significantly impact the company's cash flow and profitability.

When recording an allowance for doubtful accounts, here are the four steps to follow: 

1. Create allowance for doubtful accounts  

Companies create an allowance for doubtful accounts to recognize the possibility of uncollectible debts and comply with the matching principle of accounting. After determining the method you’ll use, you can create the account in the chart of accounts.

The accounting journal entry to create the allowance for doubtful accounts involves debiting the bad debt expense account and crediting the allowance for doubtful accounts account.

2. Adjust allowance for doubtful accounts 

After creating an allowance for doubtful accounts, it is important for companies to regularly review and adjust this account to ensure that it accurately reflects the current state of their working capital and accounts receivable.

The adjustment process involves analyzing the current accounts, assessing their collectibility, and updating the allowance accordingly.

The adjustment process often involves two steps:

1. An evaluation of the accounts: This step involves looking at all the accounts receivable, assessing the collectibility of each account, and determining the amount of allowance necessary to cover the estimated bad debts.
2. An adjustment of the allowance: The next step involves updating the allowance account—either upward or downward—to reflect the estimated uncollectible amount.

Adjusting the allowance for doubtful accounts is important in maintaining accurate financial statements and assessing financial risk.

3. Write off an account

When assessing accounts receivable, there may come a time when it becomes clear that one or more accounts are simply not going to be paid. In these cases, the best course of action is often to write off the account.

Writing off an account means removing it from the accounts receivable balance, as it is no longer considered an asset of the company. The allowance for doubtful accounts journal entry for this is to:

• Debit allowance for doubtful accounts
• Credit accounts receivable

Remember that writing off an account does not necessarily mean giving up on receiving payment. In some cases, the company may still pursue collection through a collection agency, legal action, or other means.

4. Recover an account

Recovering an account means collecting a debt that has been previously written off or deemed uncollectible. If you recover money, you’ll want to make a journal entry to adjust your books and account for the recovery. 

The journal entry is:

• Debit cash account
• Credit allowance for doubtful accounts

Recovering an account may involve working with the debtor directly, working with a collection agency, or pursuing legal action.

Allowance for doubtful accounts benchmarks

Ideally, you’d want 100% of your invoices paid, but unfortunately, it doesn’t always work out that way. Assuming some of your customer credit balances will go unpaid, how do you determine what is a reasonable allowance for doubtful accounts? It depends on your business, customers, and industry.

This table from Dun & Bradstreet shows the percentage of invoices paid on time versus those that are overdue, broken down by how late the payments are:

How to use industry benchmarks for your business

Industry benchmarks help you understand how well your business collects payments compared to peer companies in your sector.

Analyzing the data can help you make decisions about managing accounts receivable and preventing potential financial losses (more on that below). The rewards are worth it because companies with lower bad debt levels benefit from stronger revenue, healthier cash flow, and more flexibility to invest in growth.

If you find that your business has a higher level of bad debt than the industry average, take the following steps:

• Identify high-risk customers: Use your accounting software to identify chronic late payers. 
• Check credit scores: You can also run regular credit checks against customers you supply tradelines to, so you get an early warning if their financial situation changes.
• Tighten your credit policies: Make clear to all clients, especially newer ones, that you expect to be paid on time. For late payers you’ve identified, consider setting a lower credit limit, asking for a deposit, or both before starting new work. 
• Establish a “stop” point: Give customers a clear cut-off point when you won’t perform any more work for them unless they settle their balance or bring it under a certain amount. 
• Set an “outsourced collection” trigger: Consider calling a debt collection agency for debts 90+ days overdue, as they present the greatest risk of nonpayment.
• Write off uncollectible accounts: When you determine that a client will never pay an invoice, use your accounting software to formally write off the debt and reduce your taxable income.

Streamline your accounting and save time 

Creating an allowance for doubtful accounts replaces financial guesswork with strategic control. You get a realistic view of how much you’ll collect from customers, which is essential for successful cash flow and business planning. This allows you to see exactly what you have to work with, so you know whether you have enough to cover your costs and provide the financial headroom to unlock business growth.

QuickBooks accounting software provides the tools you need. Create an allowance for doubtful accounts in your chart of accounts in your general ledger. Track your sales and bad debt in one place so you have a real-time view of the financial health of your company. Use these insights to make informed spending, borrowing, and investment decisions.