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.

Characteristics of an Allowance in Accounting

The following are the key characteristics of an allowance:

In accounting, an allowance refers to an estimated amount set aside to account for specific expenses, losses, or reductions in asset values. Below are the main characteristics of allowances in accounting:

Purpose. Allowances are used to account for anticipated adjustments or reductions in asset values or to estimate future expenses. They are commonly employed to provide a more accurate picture of financial health.
Estimation. Allowances are based on historical data, trends, and the judgment of the accountant.
Matching principle adherence. Allowances ensure that expenses are recognized in the same period as the revenues they help to generate.
Conservatism principle adherence. Allowances adhere to the conservatism principle, which requires anticipating potential losses or liabilities while avoiding overstatement of assets or income.
Financial statement impact. Allowances typically appear as contra accounts in the balance sheet, reducing the gross value of related assets. The corresponding expense or loss is recognized in the income statement, affecting the reporting entity’s net income.
Ongoing adjustments. Allowances are adjusted periodically to reflect changes in estimates or actual outcomes.
Non-cash nature. Many allowances, such as the allowance for doubtful accounts, represent non-cash adjustments that impact accounting records but do not involve immediate cash flow.
Required by accounting standards. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) require the use of allowances in areas like receivables, depreciation, and inventory valuation.
Subjectivity. Determining allowances often involves judgment and estimation, making them subjective and potentially open to bias or error.
Reversals. If an allowance proves unnecessary (e.g., a doubtful account is collected), adjustments are made to reverse the allowance, restoring the asset value or recognizing income.

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.