An allowance method is a way companies calculate how many open accounts receivables they will be unable to collect. Companies that sell goods or services on account will allow customers to pay off the total charge over time. Some customers, unfortunately, never pay off their balances. When this occurs, companies must write off the dollar amount as lost sales. Using an allowance method, such as percent of sales or percent of receivables, allows companies to properly account for expected accounts receivable losses. The allowance presents a truer picture of the company’s financial position.
In order to properly create an allowance method calculation, companies must have historical records of their accounts receivable collections. The most common way companies complete this is by tracking the age of their receivable accounts. A report will list each open account by the number of days outstanding, such as 30, 60, 90 or 120 days old. As the receivables fall into the older age categories, the opportunity to collect the accounts usually decreases. Accountants work through this report to determine what percent of open receivables are noncollectable and then write them off per company policy. This record helps create an official allowance write-off method.
When using the percent of sales allowance method, accountants divide the company’s credit sales by the total sales from the company to create an allowance percentage. The credit sales usually represent the total credit sales that were not collectible during a specific time period. To create an average percentage, accountants will repeat this for several consecutive months to create the most accurate write-off percentage. This percentage will then be the factor that accountants use to determine how much of their total credit sales to write off based on sales.
The other allowance method, percent of receivables, is similar to the percent of sales method. Accountants will, however, divide the total accounts receivables by the historical accounts written off as noncollectable. This allowance method is often seen as more accurate than the sales method. As sales can increase or decrease frequently, the allowance percentage can also fluctuate wildly. Using accounts receivables as the denominator will likely reduce these fluctuations by only taking the average accounts receivable sales each month. Companies typically employ a few accountants whose job is to constantly manage the accounts receivable and collections process. Calculating the percent of bad accounts using the receivable method for bad accounts is typically a common process for these accountants.