Allowance Method

What is the Allowance Method?

Definition: The allowance method is a system that estimates uncollectable receivables and bad debts by reporting accounts receivable at its realizable value. In other words, it’s a method that management uses to estimate the amount of cash credit customers will actually pay.

What Does Allowance Method Mean?

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).

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.

Example

The allowance method works by using the allowance for doubtful accounts account to estimate the amount of receivables that are going to be uncollected in the future. Instead of directly writing off the customer balances in the account receivable account, bad debt expense is recorded by crediting the allowance account. This account is a contra asset account that is used to reduce the total outstanding receivables reported on the balance sheet.

At the end of the accounting cycle, management analyzes an aging schedule and estimates the amount of uncollectable accounts. It then makes a journal entry to record the non-creditworthy customers by debiting bad debt expense and crediting the allowance account. This is just an estimate. Other than management’s estimation, there is no reason to believe that these customers will not pay their full invoice. That’s why the entire account isn’t written off yet.

When management knows that a specific account is uncollectable, it writes off the balance by debiting the allowance account and crediting the accounts receivable account. This completely removes the customer’s balance from the accounting system.

Explanation

Unfortunately, not all customers that make purchases on credit will pay companies the money owed.   There are two methods companies use to account for uncollectible accounts receivable, the direct write-off method and the allowance method.

The direct write-off method relies on reports of accounts receivable the company has determined will not be collected.  If write off is not material, this method can be used in financial reports.  Typically, this approach is restricted to income tax returns.

The allowance method records an estimate of bad debt expense in the same accounting period as the sale.  It often takes months for companies to identify specific uncollectible accounts.  The allowance method follows the matching principle, which states revenues need to be matched with the expenses incurred in that same accounting period.

Generally, companies will choose between two approaches under the allowance method.

Percentage of Sales:  Using historical data, a company examines the relationship between sales and uncollectible accounts receivable.  If there is a fairly stable relationship between the two, a company will use the historical Uncollectible Accounts / Credit Sales ratio to estimate the bad debts expense in the current period.

For example, a company might find a historical trend indicating 2% of credit sales are never collected from customers.  If that company had $100,000 of credit sales in the current period, it would also record the following journal entry:

DateAccountDebitCredit
3/31/20XXBad Debts Expense$2,000
Allowance for Doubtful Accounts$2,000

This method is sometimes referred to as the income statement approach.

Percentage of Accounts Receivable:  Using historical data, a company examines the relationship between accounts receivable and uncollectible accounts.  Companies will oftentimes increase the accuracy of these estimates by looking at their aging schedule for patterns, rather than using a composite (or total) of their receivables.

For example, a company might find a historical trend indicating 50% of credit sales over 150 days due are never collected, while 0.5% of credit sales over 30 days are never collected.  This approach is illustrated below:

Aging ScheduleBad Debts EstimateA/R BalanceAllowance for Bad Debts
Over 30 days0.5%$300,000 $1,500
31 to 60 days1.0%$100,000$ 1,000
61 to 90 days2.0%$50,000 $1,000
91 to 120 days5.0%$7,000 $350
120 to 150 days15.0%$5,000 $750
Over 150 days50%$3,000 $1,500
Total Balance $6,100

This method is sometimes referred to as the balance sheet approach.

Allowance for bad debt, also known as the allowance for doubtful accounts, is a contra asset account and is used as an offset to accounts receivable.  This allows the account to be stated in what is known as net realizable value, where:

Net Realizable Value = Accounts Receivable - Allowance for Doubtful Accounts

Allowance Method Based on Credit Sales

Assume further that KX Textiles has determined that the credit sales approach provides a better estimate of bad debt, and that management estimates future non-collectible debt will be 3 percent of credit sales. Estimated non-collectible debt will be calculated as follows: $450,000 times 3 percent equals estimated debt of $13,500. The journal entry to record the estimate is as follows: (DR.) Bad debt expense 13,500 (CR.) Allowance for doubtful accounts 13,500 The allowance for doubtful accounts now has a balance of $17,500, which includes the previous balance of $4,000 plus the current year estimate of $13,500. Notice that the sales approach increases the prior year balance.

Allowance Method Based on Accounts Receivable

Assume instead that KX Textiles uses the accounts receivable approach, and management estimates non-collectible accounts at 9 percent of accounts receivable. Non-collectible debt will be estimated as follows: $120,000 times 9 percent equals required allowance balance of $10,800. Next, the already existing balance of $4,000 must be subtracted from this required balance, leaving the required adjustment to the allowance account at $6,800. The journal entry to record the estimate is as follows: (DR.) Bad debt expense 6,800 (CR.) Allowance for doubtful accounts 6,800 Notice that unlike the sales approach, the accounts receivable approach does not ignore the prior year’s balance and simply increase the allowance account. Instead it adjusts the balance to meet the required balance that is based on the current year’s receivable account.

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