What is an Allowance in Accounting?

An allowance is a reserve that is set aside in the expectation of expenses that will be incurred at a future date. The creation of a reserve essentially accelerates the recognition of an expense into the current period from the later period in which it would otherwise have been recognized. The intent of a reserve is to match expenses with the sales transactions with which they are associated. For example:

An allowance is created for bad debts that are expected to arise from invoices sent to customers.
An allowance is created for sales returns that are expected from current shipments to customers.
An allowance is created for warranty claims expected from current shipments to customers.

Example of an Allowance in Accounting

The controller of Games Corporation has noticed a spike in the returns of several of its board games, with the complaint that the boards are delaminating. Further investigation reveals that the company received a bad batch of cardboard from a supplier, so it must be presumed that the entire batch will be returned by customers. This will result in a maximum of $200,000 of games being returned. Accordingly, the controller sets up a $200,000 allowance for warranty claims.

A few months later, the controller notes that only $50,000 of warranty claims were made in relation to the delamination problem, and that the warranty period has expired for these games. Accordingly, he reverses the remaining $150,000 of the allowance, since it will never be used.

What is an Allowance in Sales?

The "allowance" term can also be used from the perspective of a customer order, where the sales staff gives an allowance that is essentially a price reduction, perhaps based on year-to-date order volume, or because an order is being placed within a time period designated as being subject to a discount.

What is an Allowance in Employee Travel?

The allowance concept can also apply to per diem travel and entertainment arrangements, where employees are paid a certain amount per day for their travel expenses, irrespective of the actual amount incurred. This practice can give rise to extreme frugality by employees, in order to earn a profit on the per diem amounts paid to them.