The allowance method definition
/What is the Allowance Method?
The allowance method involves setting aside a reserve for bad debts that are expected in the future. The reserve is based on a percentage of the sales generated in a reporting period, possibly adjusted for the risk associated with certain customers. By creating this allowance, bad debt expenses are being matched against sales within the same period, so that readers of the financial statements will have a better understanding of the true profitability of sales.
Accounting for an Allowance
The mechanics of the allowance method are that the initial entry is a debit to bad debt expense and a credit to the allowance for doubtful accounts (which increases the reserve). The allowance is a contra account, which means that it is paired with and offsets the accounts receivable account. When a specific bad debt is identified, the allowance for doubtful accounts is debited (which reduces the reserve) and the accounts receivable account is credited (which reduces the receivable asset). If a customer subsequently pays an invoice that has already been written off, then the process is reversed to increase both the allowance and the accounts receivable account, after which the cash account is debited to increase the cash balance and the accounts receivable account is credited to reduce the receivable asset.
Related AccountingTools Courses
Credit and Collection Guidebook
Example of the Allowance Method
The historical bad debt experience of a company has been 3% of sales, and the current month’s sales are $1,000,000. Based on this information, the bad debt reserve to be set aside is $30,000 (calculated as $1,000,000 x 3%). In the following month, $20,000 of the accounts receivable are written off, leaving $10,000 of the reserve still available for additional write-offs.
Advantages of the Allowance Method
There are several advantages associated with using the allowance method, which are as follows:
Matches revenues to expenses. The allowance method adheres to the matching principle in accrual accounting. This principle ensures that bad debt expenses are recognized in the same period as the revenues they relate to, providing a more accurate representation of a company’s financial performance.
Improved balance sheet accuracy. By creating an allowance for doubtful accounts, the method adjusts the accounts receivable to reflect the amount expected to be collected. This provides a more realistic value of assets on the balance sheet, avoiding overstating accounts receivable.
Smooths financial results. Because bad debt expenses are estimated and recorded periodically, the allowance method prevents large and sudden expenses in financial statements. This creates more consistent financial reports, which are easier to analyze and interpret.
Supports better decisions. The allowance method provides insight into the company's expected credit losses. This can help management make informed decisions about credit policies, collections strategies, or customer evaluations.
Better GAAP compliance. The allowance method is required under Generally Accepted Accounting Principles (GAAP), especially for companies using accrual accounting.
Assists risk management. Estimating uncollectible accounts proactively allows a company to monitor credit risk more effectively. Management can assess trends in customer defaults and adjust their credit policies accordingly.
By using the allowance method, companies align their financial statements more closely with the economic realities of credit sales, thereby improving the reliability and usefulness of their financial data.
The Direct Write-Off Method
The alternative to the allowance method is the direct write-off method, under which bad debts are only written off when specific receivables cannot be collected. This may not occur until several months after a sale transaction was completed, so the entire profitability of a sale may not be apparent for some time. The direct write-off method is a less theoretically correct approach to dealing with bad debts, since it does not match revenues with all applicable expenses in a single reporting period.