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 has two distinct advantages over the direct write-off method for estimating bad debt expense. First, the allowance method agrees with the matching principle by recording an estimated bad debt expense in the period in which the related sale takes place. Second, it reports accounts receivable on the balance sheet at its realizable value. This means that investors and creditors will be able to see how much cash management is expecting to collect from its current customers on account. The direct write-off method does not report either of these.
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.
