Definition:
The allowance method is a method used to estimate and account for bad debts. It involves creating an allowance for doubtful accounts, which is a contra asset account that estimates the amount of accounts receivable that a company expects to be uncollectible.
Key points about the allowance method:
- Estimate: The allowance for doubtful accounts is an estimate based on historical data, industry averages, or other factors.
- Aging method: A common method for estimating the allowance for doubtful accounts is the aging method, which categorizes accounts receivable by age and assigns different percentages to each age group based on the likelihood of collection.
- Write-offs: When an account receivable is deemed uncollectible, it is written off against the allowance for doubtful accounts.
- Matching principle: The allowance method helps to match the revenue from credit sales with the related expense of uncollectible accounts.
Why is the allowance method used?
- Matching principle: The allowance method helps to match revenue with expenses in the same period, which is a key accounting principle.
- Accurate financial statements: It helps to ensure that financial statements accurately reflect the net realizable value of accounts receivable.
- Cash flow management: Understanding the allowance for doubtful accounts can help businesses manage their cash flow by anticipating potential losses from uncollectible accounts.
In essence, the allowance method is a valuable tool for estimating and accounting for bad debts, ensuring that financial statements accurately reflect the expected losses from uncollectible accounts receivable.
