Allowance method is a receivable process of uncollectible amount. The receivable amount is nothing but the due amount as a credit sale from the customer. The receivable amount may remain unpaid by the customer due to certain reasons. This need to be estimated and recorded in the same duration of the credit sales. Two methods are used by companies to estimate uncollectible accounts. They are direct write-off and allowance method. In the direct write-off method, when the amount remains unpaid by the customer this is recorded in a different period. The estimate is recorded in different period from original sale.
The allowance method is contrast to the direct write-off method. It obeys the matching principle in which the estimated bad debt expense is recorded in the same period. In allowance method the allowance needed should be estimated using suitable method. The methods used to estimate allowance fall under two categories, income statement approach and balance sheet approach. In the income statement approach balancing figure is the allowance and the bad debt expense will be calculated. In balance sheet approach bad debt expense is balancing figure and ending balance will be calculated. Allowance can be calculated using these three methods-Sales percent technique (profit or loss strategy), Percentage of collectible accounts technique (annual report strategy) and Age based accounts collectible technique (annual report strategy).
Sales percent technique
The formula for sales percent technique is:
{\text{Percentage of uncollectible expense on credit sales }} = \frac{{{\text{Sum of uncollectible expense}}}}{{{\text{Sum of total credit sales}}}}{\text{ }} \times {\text{ }}100Percentage of uncollectible expense on credit sales =
Sum of total credit sales
Sum of uncollectible expense
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× 100
The sales percent technique falls under the category of income statement approach.
In this method, credit sales made in the same period is used in estimating bad debt expense. The percentage of this method is based on the past bad debts of the business.
This method estimates the uncollectible accounts directly and it is recorded in the income statement as an expense.
Allowance of doubtful accounts contained in the balance sheet is increased by the journal entry. The journal entries are nothing but the adjustments made at the end of accounting period .
The adjustments are made without considering the existing balance on the allowance account. Allowance account will be increasing without considering the accounts receivable.
Percentage of collectible account technique
The formula for percentage of collectible accounts technique is:
{\text{Allowance for uncollectible expense }} = \left( \begin{gathered}{\text{Ending accounts receivable }} \times\;{\text{fixed \% of uncollectible expense }}\end{gathered} \right)Allowance for uncollectible expense =(
Ending accounts receivable ×fixed % of uncollectible expense
​
)
This method falls under the category of annual report strategy.
The percentage of collectible technique first calculates the allowance for doubtful amounts using the data from the balance sheet of business. It calculates the bad debt expense indirectly.
The uncollectible account is estimated from the movement on the allowance for doubtful accounts. In this method the allowance for doubtful accounts is calculated using percentage of account receivable in the end of the accounting period.
The amount of accounts receivable in balance sheet at the end of the period is given by the balance on allowance account. The percentage used is based on the past bad debt of the business.
