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Allowance Method

The allowance method in accounting attempts to estimate what a company's uncollectible accounts receviable will be when sales are made or when the balance sheet is prepared. In this way, we try to estimate bad debt expenses are and recognized in the same period that the revenues they helped earner are recognized. Similarly, when we prepare the balance sheet, this allows us to recognize accounts receivable on the balance sheet at an amount closer to their net realizable value, assuming some accounts will never be collected. 

There are two main approached to the allowance method: the income statement approach and the balance sheet approach. The income statement approach better matches bad debt expenses with revenues, and the balance sheet approach does a better job at representing the true value of accounts receivable on the balance sheet. You'll understand why below. In both cases we use a contra asset account that offsets accounts receivables on the balance sheet called Allowance for Doubtful Accounts

The Income Statement Approach

The income statement approach estimates bad debt expenses based on total credit sales for the period. Sales, we know, is found on the income statement, and only represents sales made in this period. If there is a pretty stable relationshio between the amount of credit sales a company makes in previous periods, and the amount of these sales that become uncollectible, we can estimate what are future bad debt expense will be by estimating, based on historical information and market conditions. This is called the percentage-of-sales approach, and it does an excellent job matching bad debt expenses with revenues.

For example, if we made $100,000 of credit sales in the previous period, and we know from experience that approximately 2% of sales are uncollectible, we would record at the end of the period an estimated bad debt expense of $2,000. 

The Balance Sheet Approach

Instead of the income statement approach, a company may choose to estimate their bad debt expense based on the amount of receivables outstanding. This is called the percentage-of-receivables approach, and does a good job at representing accounts receivabe at their true value on the balance sheet, even if it doesn't do as good of a job matching expenses with revenues. 

A popular approach is to set up an aging schedule, which looks at the age of each receivable and applies a different perentage based on the likelyhood that each age of receivable will be collected. 

For example, based on past experience a company knows that 2% of accounts receivables under 30 days will be uncollected, 4% of accounts receivable between 30 and 60 days will be uncollected, 15% of accounts receivable between 60-120 days will be uncollected, and 25% of receivables over 120 days will be uncollected. 

The corresponding entry at the end of the year to recognize estimated bad debt expenses would be:

Asssume, however, that the allowance for doubtful accounts already had a credit balance of $4,000. At the end of the year, we would make an entry of $5,650 in order to simply raise the credit balance in the allowance for doubtful accounts to the required $9,650. 

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