Lesson Objectives:- Why the allowance method is used.
- How defaults affect financial statements.
- The accounts involved in the allowance method.
- Using the matching principle.
We introduced the allowance method in the previous lesson, and described that it is a way to make sure financial information is reported more consistently. The method requires the company to create an allowance for bad debt, instead of overstating net income and accounts receivable figures.
When companies offer conservative interest rates or easy credit terms, it introduces the risk for default which means the company would not be able to collect on the receivables.
In order to use the allowance method, companies must estimate the uncollectibles amount and record the appropriate journal entry, which we will be discussing later in this lesson.
The reality of the accounting world is that every sale that a company makes is not always a good sale. There is a strong chance that they will not be able to collect every receivable.
When sales are defaulted, the company will need to adjust their accounts receivable and net income figures.
Without the allowance method, both the balance sheet and income statement will have inaccurate values because they would be making the assumption that all sales are collectible.
Therefore, we need an account that will adjust the accounts receivable and net income to bring the accounts to their fair value. The allowance method records the bad debt expense and will help to ensure all of the financial statements have accurately stated accounts receivable and net income figures.
This helps to ensure consistently and truthful delivery of financial information to investors and other users of information.
First, let's take a look at the account that will bring the net income to its true value, which is known as the bad debts expense account. This account is an expense account that will decrease the amount of net income.
Next, we need the contra account that will correct the accounts receivable account which is known as the allowance for doubtful accounts. The company will assign a certain amount that is the "allowance" for the uncollectible receivables.
As you can see from the journal entry format above, the way that these accounts are recorded is by journalizing the bad debts expense as a debit and the allowance for doubtful accounts as a credit.
We are matching the expenses and assigning a net realizable value for the accounts receivable by using the contra account to offset the bad debts. This entry falls in line with the matching principle as the expenses are matched with the sales revenue.
There are two methods that they can use to come up with the allowance figure: the sales method and the receivables method, which we will review in the upcoming lessons.