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.
An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable. The allowance, sometimes called a bad debt reserve, represents management’s estimate of the amount of accounts receivable that will not be paid by customers. If actual experience differs, then management adjusts its estimation methodology to bring the reserve more into alignment with actual results.
In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the accuracy of financial reports. The projected bad debt expense is properly matched against the related sale, thereby providing a more accurate view of revenue and expenses for a specific period of time. In addition, this accounting process prevents the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses.
Units should consider using an allowance for doubtful accounts when they are regularly providing goods or services “on credit” and have experience with the collectability of those accounts. The following entry should be done in accordance with your revenue and reporting cycles (recording the expense in the same reporting period as the revenue is earned), but at a minimum, annually.
DR Bad Debt Expense
CR Allowance for Doubtful Accounts
6330 | Bad Debt Expense | Write off of uncollectable Accounts Receivable. Use: Use with approval from the Division of Financial Affairs only. |
1250 | Allowance for Doubtful Accts | Allowance for Doubtful Accounts is a contra current asset object code associated with A/R. When the allowance object code is used, the unit is anticipating that some accounts will be uncollectible in advance of knowing the specific amount. Use: Units billing sales to external customers where the possibility of default exists. The allowance normalizes fund balance activity. |
When it is determined that an account cannot be collected, the receivable balance should be written off. When the unit maintains an allowance for doubtful accounts, the write-off reduces the outstanding accounts receivable, and is charged against the allowance – do not record bad debt expense again!
DR Allowance for Doubtful Accounts
CR Accounts Receivable
For detailed expectations and guidelines related to write offs, see Writing Off Uncollectable Receivables.