Why allowance for doubtful accounts matters to a first-time founder
The allowance for doubtful accounts shows that some customer invoices may not be paid in full. It is a contra-asset, meaning an account that reduces the asset balance. Showing receivables after this allowance gives founders and investors a more realistic amount and can reveal worsening payment behaviour.
Examples of allowance for doubtful accounts
A distributor is owed £120,000 by customers and estimates that £6,000 will not be collected. Its balance sheet therefore shows £114,000 after the allowance. If a particular £2,000 invoice is later written off, the company generally reduces the allowance instead of recording the whole loss at that point.
Common misunderstanding
The allowance is not the same as writing off a particular invoice, and it is not cash set aside. Terms such as bad-debt allowance and credit-loss allowance can mean different things under different accounting rules or within different organisations. Do not assume they cover the same debts or use the same calculation.
When to use it
Use it when customers owe significant amounts and the company must estimate what will go unpaid. At each reporting date, review individual customer risks, how long invoices have been outstanding and relevant forecasts. Compare estimates with later write-offs and recoveries, and follow the relevant accounting rules.