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.
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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
The main advantage of the allowance method is that it recognizes all expenses related to a revenue-generating event in a single reporting period. This allows the readers of a company’s financial statements to gain a true picture of its profitability, rather than having to discern it from the results issued over several reporting periods.
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.