Definition of Allowance Method
The allowance method usually refers to one of the two ways for reporting bad debts expense that results from a company selling goods or services on credit. (The other way is the direct write-off method.)
Under the allowance method, a company records an adjusting entry at the end of each accounting period for the amount of the losses it anticipates as the result of extending credit to its customers. The entry will involve the operating expense account Bad Debts Expense and the contra-asset account Allowance for Doubtful Accounts. Later, when a specific account receivable is actually written off as uncollectible, the company debits Allowance for Doubtful Accounts and credits Accounts Receivable.
The allowance method is preferred over the direct write-off method because:
- The income statement will report the bad debts expense closer to the time of the sale or service, and
- The balance sheet will report a more realistic net amount of accounts receivable that will actually be turning to cash
The allowance method can be applied in one or both of the following ways:
- Focusing on the bad debts expense that is needed on the income statement
- Focusing on the balance needed in Allowance for Doubtful Accounts (which will be reported on the balance sheet)
Examples of Allowance Method
Let's assume that a corporation begins operations on November 1 in an industry where it is common to give credit terms of net 30 days. In this industry approximately 0.3% of credit sales will not be collected.
Next, let's assume that the corporation focuses on the bad debts expense. If the corporation's actual credit sales for November are $800,000 it will record an adjusting entry dated November 30 to debit Bad Debts Expense for $2,400 ($800,000 X 0.003) and credit Allowance for Doubtful Accounts for $2,400. As a result, its November income statement will be matching $2,400 of bad debts expense with the credit sales of $800,000. If the balance in Accounts Receivable is $800,000 as of November 30, the corporation will report Accounts Receivable (net) of $797,600.
Focusing on the balance in the account Allowance for Doubtful Accounts, the corporation will adjust the balance in the account Allowance for Doubtful Accounts so that the combination of that credit balance and the debit balance in Accounts Receivable will be equal to the amount that is expected to turn to cash. The expected amount will likely be determined by aging the accounts receivable.
If the corporation prepares weekly financial statements, it might focus on the bad debts expense for its weekly financial statements, but at the end of each quarter focus on the allowance account.