The allowance method is used to account for potential bad debts that may occur within a company’s sales.
Explanation:
Companies aim to increase income and avoid expenses as much as possible. However, some expenses are unpredictable. For example, bad debt expenses occur when clients make purchases but do not pay for them. Uncollectable accounts can be dealt with via the allowance method or the direct write-off method.
The direct write-off method has various restrictions, and although it can be used in a financial report, it does not immediately reduce the recorded sales amount. Alternatively, the allowance method for bad debts has several benefits and aims to balance the company’s expenses in the long-term.
The allowance method in accounting creates a financial reserve for potential uncollectable debts, which are estimated based on a company’s sales during a reported period. This reserve helps adjust for risks from certain customers and avoid a surge in expenses.
The allowance method formula relies on the percentage of bad debts in the company’s history and on its current economic situation. For example, if the company’s credit sales come to $100,000, and the company deduces a trend of 3% of sales that are unable to be collected, a journal entry in the company’s financial record system will appear as follows:
In this way, potential expenses are written off so as not to influence the company’s net value, as seen in a comparison of the records before and after write-off. If the company foresees possible expenses from doubtful accounts, it can write them off beforehand. This method differs from the direct write-off method, through which profitability can not be clearly observed for some time. The allowance method helps avoid delays in payments and ensures a company’s financial stability.