ALLOWANCE METHOD Meaning and
Definition
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The allowance method is an accounting technique used to estimate and record potential losses from uncollectible accounts receivable. It is a method that adheres to the principle of conservatism, ensuring that financial statements reflect a realistic estimate of the company's potential losses due to customers' failure to pay their debts.
Under the allowance method, a company establishes an allowance for doubtful accounts, which is a contra-asset account representing the estimated amount of accounts receivable that will not be collected. This allowance is based on historical data, industry trends, customer creditworthiness, and other relevant factors.
To record bad debt expense and create the allowance for doubtful accounts, companies typically use one of two approaches: the percentage of sales method or the percentage of receivables method. The percentage of sales method estimates bad debts as a percentage of total sales, while the percentage of receivables method estimates bad debts as a percentage of accounts receivable.
When a specific account is deemed uncollectible, it is written off by debiting the allowance for doubtful accounts and crediting the accounts receivable. The write-off reduces both the accounts receivable and the allowance for doubtful accounts, reflecting the actual loss incurred.
The allowance method allows companies to more accurately report their assets and net income by recognizing potential bad debts before they actually occur. It provides a more realistic reflection of a company's financial position and aids in making informed business decisions.
Etymology of ALLOWANCE METHOD
The word allowance comes from the Old French aloance, which is derived from the verb alouer meaning to allot or to assign. It entered the English language around the 14th century.
The word method originates from the Latin word methodus, which combines the Greek words meta meaning after or beyond and hodos meaning way or journey. The term was first recorded in English during the late 16th century.
Therefore, the etymology of the phrase allowance method itself is a combination of the French loanword allowance and the Latin loanword method.
