allowance method
Picture a careful shopkeeper who, at the end of each year, sets aside a small cushion of money in anticipation of the few customer debts that experience says will go bad — without yet knowing which ones. By preparing for the loss in advance, the shopkeeper's year-end numbers tell the truth about how much is really collectible. The allowance method is this disciplined, prepare-in-advance approach to bad debts.
Under the allowance method, a company estimates the expected uncollectible amount each period and records two things at once: a bad debt expense on the income statement, and an increase in the allowance for doubtful accounts (a contra-asset that reduces receivables on the balance sheet). The estimate can be made as a percentage of credit sales, or — more precisely — by aging the receivables and applying higher loss rates to older balances. When a specific customer is later confirmed uncollectible, the account is written off against the allowance, with no new expense, because the loss was already recognized. If that customer surprisingly pays after all, the entry is simply reversed.
This is the method required by GAAP and IFRS for financial reporting, precisely because it honors the matching principle and reports receivables at net realizable value — the realistic amount expected in cash. It does rely on estimates, so the allowance is only as good as the company's judgment and history; estimates that are too low flatter current profit, and estimates that are too high understate it, which is one reason auditors examine the allowance closely.
A company estimates 5,000 of its receivables will go bad this year. It records 5,000 of bad debt expense and a 5,000 allowance now. Months later, a specific 800 account is confirmed worthless and written off against the allowance — receivables and the allowance each drop by 800, and no new expense is recorded.
Estimate the loss up front, then absorb each specific write-off against the cushion already set aside.
The method is only as reliable as its estimates; because the allowance is a judgment call, it is a classic place where reported profit can be quietly smoothed or manipulated.