Allowance for Doubtful Accounts

Under accrual accounting, revenue is recognized when earned, not when cash is collected. The matching principle requires that the cost of revenues you'll never collect be recognized in the same period as the related sale. Rather than wait until a specific customer defaults, companies estimate uncollectibles up front via bad debt expense, building the allowance. This keeps net income from being overstated in the sale period and understated later. It's a direct application of accrual vs. cash accounting — conservatism demands you anticipate the loss when it becomes probable, not when it's confirmed.

Two main methods. The percentage-of-receivables (aging) method applies escalating loss rates to receivables grouped by how overdue they are — e.g., 1% on current invoices, 10% on 60-day-past-due, 50% on 120+ days. The percentage-of-sales method applies a historical bad-debt rate to credit sales. Under current accounting (CECL / IFRS 9 expected-loss models), companies must estimate lifetime expected credit losses up front. The key mechanic: recording bad debt expense increases the allowance (a credit) and hits the income statement (a debit), while an actual write-off reduces both gross AR and the allowance with no income statement impact — the loss was already recognized.

Recording bad debt expense lowers net income on the income statement. On the cash flow statement, it's a non-cash charge added back to net income (no cash left the building — you just lowered the carrying value of receivables). On the balance sheet, the allowance rises, reducing net AR, and retained earnings fall by the after-tax expense. A write-off, by contrast, is balance-sheet-only: gross AR and the allowance both drop by the same amount, leaving net AR — and net income — unchanged. Analysts watch the allowance-to-gross-AR ratio: a shrinking allowance into a recession can signal earnings management.