What is the Allowance Method? (Definition, Calculation, Example, and More)

Definition

The allowance method is used in accounting to create contra for the debtors that are expected to be uncollectible.

Sometimes, the direct write-off for the account balance does not seem logical as the business may be unable to locate which debtor should be written off.

So, the allowance method allows organizations to create a general reserve for bad debt that can be used when the business needs to write off specific balances.

The process is also encouraged by the prudence concept of accounting, as bad debt expense is recorded before the actual write-off.

Further, the creation of the reserve is based on the balance of receivables or the percentage of sales generated by the organization during a specific reporting period under consideration.

The reserve is created due to the business’s nature and the risks associated with the collectability of the customer’s balances.

Moreover, when an organization creates an allowance for bad debts, they are considered expenses.

When the organization’s financial statements are finalized, these expenses are reviewed by the higher management to understand the financial reporting process better and control the business’s credit aspects.

If there is a higher amount in write-off, it might trigger significant changes in the credit policy.

In addition, from an audit perspective, the default risk of debtors is an overstatement. The creation of the allowance helps to bring an element of fairness to the financial statement as the net balance is shown after deducting the provision.

However, excess allowance creation can significantly reduce the accounting profit, which can also be questioned.

Accounting aspects for write off

The allowance method for accounting uses mechanics that consist of debiting bad debt expenses and crediting the allowance for doubtful accounts at the beginning of the process.

Accounts receivable are paired with the allowance, and the allowance is offset against it.

Further, allowance for doubtful accounts is debited when the debtor balance is identified as written off.

Similarly, an account receivable is credited when writing off a specific balance.

Over time since an invoice was written off, a customer may unexpectedly pay an invoice. In such a case, the process is reversed, and accounts receivable are reinstated to be treated like a normal debtor collection.

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The Application of Allowance method

The reserve is created opposite to the assets to record the amount required for doubtful debtors. Later, the allowance for doubtful accounts is used instead of bad debt expense to offset losses resulting from nonpayment from customers.

This is because allowance for receivables already exists in the books of accounts,

The estimated bad debt expense at the end of each year can be recorded as follows:

ParticularsDebitCredit
Bad Debt ExpenseXXXX 
Allowance for Doubtful Accounts     XXXX

The debit impact of the above-given journal entry is the recording of the expense in the income stated that leads to a reduction in the profitability.

In contrast, the credit side of the journal entry creates a contra account to adjust the overstated debtor in the form of uncollectible assets.

A customer account would be written off as follows when we use the allowance method:

ParticularsDebitCredit
Allowance for Doubtful Accounts    XXXX 
Accounts Receivables XXXX

The debit impact of the journal entry is the removal of the allowance from the accounting book. The credit side leads to eliminating the account balance not expected to be collected from customers.

The amount for the allowance is calculated as a percentage of the sales or debtor balance. In the Sales method, a certain percentage is applied to the sales amount to create a reserve.

Creating reserves for credit sales in the same accounting period is a more logical approach that satisfies the matching concept of accounting.

Let’s understand how the reserve is created based on the sales method.

Example

The following data is required to calculate the bad debt allowance for the

Bad debt = 2% of sales,

Current month’s sales = $1,000,000

Calculate bad debt expenses for the organization in terms of $?

= $1,000,000 x 2%

= $20,000

The figures that are being reported in the Income statement will be $20,000

And in the balance sheet, the account receivable will show the balance of $980,000 (1,000,000-20,000)

The Direct Write-Off Method

The direct write-off is another alternative to allowances. It applies only to receivables that can’t be collected, and bad debts can only be written off if the company or the organization cannot collect them.

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The sale results may not be available for several months after it is completed. So, It may take some time to determine if a sale was profitable.

Hence, the direct write-off method is less accurate than the indirect write-off method because the direct method does not comply with the matching principle of accounting; in simple words, an expense for bad debt is charged in later periods, and sales are made earlier in earlier periods.

So, there is a mismatch.

Moreover, the following treatment is made to record the bad debt expense under the direct method.

ParticularsDebitCredit
Bad Debts Expenses    XXXX 
Accounts Receivables XXXX

The debit impact of this journal entry is the same as in the case of the indirect method. However, credit entry eliminates the debtor’s balance from the books without taking away allowance creation.

From a control perspective, the use of the direct method can be a little risky, it’s because if there are no sound controls manager might write off balances in a personal capacity.

Further, during analytical testing, it can be difficult to assess if the removal of the debtor balance was due to collection/write-off.

On the other hand, writing off through the allowance method helps to locate the creation of provision, use of the provision, reversal, etc.

Hence, the indirect method is of more use from an analysis perspective.

It’s important to note that both methods aim to eliminate uncollectible debtors and present a true and fair view of the business. However, there is a difference between allowance creation and a direct write-off.

It’s equally important to note that only a direct method of write-off is acceptable under the income tax reporting statute of the United States.

So, any provision in the accounting record is added back to calculate the taxable income. However, if you have written off the account balance, it can be deducted on a business income tax return to get relief.

Conclusion

The allowance method is used in accounting to write off the debtors. Since it may not be easy for the business to identify which parties will not pay their money back, they set up some general reserve in proportion to the credit sales during the period.

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This helps to satisfy the matching principle of accounting. An alternate way is to provide an allowance based on the debtor’s balance.

An allowance account is a contra account for the assets; the amount is recorded in this contra account to offset overstated debtors that the business cannot collect.

Once it’s identified which parties won’t be paying, the allowance and their balance are removed from the books.

Frequently asked questions

  • What is the difference between a direct write-off and allowance methods?

When it comes to the direct write-off method, all the bad debts of the organizations are charged to the expense account.

Besides, when it comes to creating an allowance, the organization creates a reserve account, and the amount for the bad debts nets off against that reserve.

  • What is the allowance method for uncollectible accounts?

Whenever there is bad debt, there is a reserve account for all these bad debts as the organizations use accrual methods to record the transactions.

And with this, the total amount of uncollectable accounts appears in the reserve account for financial reporting purposes.

  • How can estimates be calculated for the allowance method?

Every organization creates a reserve account for all bad debts. And the estimates being made by these organizations are based on the number of sales being made for the reporting year.

Furthermore, this is called an income statement or statement of the comprehensive income approach.

Further in the same year, when this bad debt amount reaches the accounts receivables, it converts into the balance sheet, netting both figures.

  • Why is the allowance method preferred?

Compared to the direct write-off method, the allowance method is preferred because of its usefulness and applicability.

As for the sale or service, the income statement will report the bad debt expense, and accounts receivable will be listed on the balance sheet to reflect the actual amount turning into cash.

  • How do you use the allowance method?

Allowances are a way of preparing for future bad debts by setting aside reserves. Furthermore, the reserves are calculated based on a percentage of sales generated over the period in a reporting year, perhaps with an adjustment for the risk associated with certain customers who don’t possess the credibility to pay off their debts or invoices.