The allowance method is used to calculate the amounts to be reported on a corporation's financial statements as the result of selling goods and/or providing services on credit. (However, a U.S. corporation should use the direct write-off method for calculating the amount for its income tax return.)
Under the allowance method, the corporation should record 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 adjustment that increases the amount of the losses is a debit to the operating expense account Bad Debts Expense and a credit to the contra-asset account Allowance for Doubtful Accounts. Under this method, the entry to write off a specific uncollectible account will require a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable.
There are two reasons why the allowance method is preferred over the direct write-off method:
- The income statement will report the bad debts expense earlier, and
- The balance sheet will report a more realistic net amount of accounts receivable
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)
We will contrast these two techniques by assuming 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.
Focusing 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 and credit Allowance for Doubtful Accounts for $2,400 ($800,000 X 0.003). As a result, the November income statement will be matching $2,400 of bad debts expense with the credit sales of $800,000. If no amounts were collected as of November 30, the balance sheet will report Accounts Receivable of $800,000 minus a $2,400 credit balance in the Allowance for Doubtful Accounts for a net amount of $797,600.
Focusing on the allowance for doubtful accounts. With this balance sheet focus, a corporation will adjust the balance in the account Allowance for Doubtful Accounts so that the combination of its 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 is often determined by aging the accounts receivable.
Focusing on both. A corporation that prepares weekly financial statements might prepare weekly adjusting entries that are focused on the amount of bad debts expense reported on the income statement. However, at the end of each fiscal quarter its adjusting entry will be focused on reporting the most realistic amount for the allowance for doubtful accounts that will be reported on the balance sheet.