The Financial Accounting Standards Board, or FASB, is the authority on the generally accepted accounting principles, or GAAP, that companies use to maintain their books and records. FASB establishes the conditions that must exist before a company can set up an allowance account for bad debts. Given the subjective nature of assessing whether a debt is collectible or not, these conditions are flexible and allow for alternative accounting methods.

Allowance for Bad Debt Basics

Companies that allow customers to purchase goods and services on credit realize that, for a wide range of reasons, some invoices will never be paid. And since FASB's goal is accurate financial reporting, an allowance for bad debts account is necessary to report an estimate of the amounts companies don't reasonably expect to receive. In a nutshell, management estimates total bad debts and immediately reports it as an expense on the income statement. This bad debt estimate also increases the balance in the company's allowance for bad debts account and is subtracted from accounts receivable to report a more realistic net receivables balance.

Estimates Based on Sales

One way to estimate the amount of bad debt to post to the allowance account is to use a percentage – based on the company's collections history -- of total credit sales. A vital condition of using this method is the availability of accurate financial and collections data from prior periods. For example, suppose this is the third year your company has been in business, and it reported credit sales of $100,000 in both the first and second years. If the company was only able to collect 98 percent, or $98,000, of the first year's sales and 97 percent, or $97,000, of the second year's, you can use the average of the two rates to estimate the amount to post to the allowance account. This means your allowance estimate may be 2.5 percent of all credit sales made during the current reporting period.

Estimates Based on Accounts Receivable

In many cases, the more overdue an invoice is, the less likely it is to be paid, which is why aging receivable reports are used to estimate a company's bad debts. You can run an aging receivables report, for example, to provide three balances: one for invoices that are 30 days or less past due, another for invoices between 31 and 60 days late and a third balance that includes invoices that are more than 60 days past due. You also need historical financial data that provide the percentage of credit revenue that was never collected and written off for each category. Multiplying the balance for each category of days past due by these percentages and adding the results together yields your estimate to add to your company's allowance account.

Evaluating Customer Accounts

Although FASB allows businesses to estimate bad debts, one of the conditions imposed by GAAP is that your accounts receivable account remain unaffected by the allowance estimates until you write off specific invoices. To illustrate, suppose you learn that one of your customers who has an outstanding invoice for $1,000 just filed for bankruptcy. At this time, you write off the invoice by crediting, or reducing, accounts receivable and debiting the allowance account by $1,000.