The allowance method of accounting for bad debts is the accounting method in which a provision is made for estimated bad debts in an accounting period by setting aside certain percentage of total sales revenues. Any excess or shortfall of this amount is adjusted in the following accounting period. Another method is the direct write off method, the main purpose of using the allowance method of accounting for bad debts is to minimize the risk of possible financial losses at cost of taking into account bad debts and the possibility of their loss. In other words, the allowance method implies the writing off bad debts which may never be returned to the company. In such a way, the company can maintain accurate accounting and assess its financial position objectively. The company is likely to lose bad debts because they are unlikely to be returned. If the company keeps these debts and takes them into consideration, the company is likely to obtain misleading information concerning its financial position since the company will consider bad debts as debts that the company will return some day that is not true. After writing off those debts the company can assess its financial position objectively and accurately.
The effect of allowance method on the balance sheet and income statement is very significant. The use of the allowance method on the basis of the percentage sales affect the income statement because the percentage of sales basis results in a better matching of expenses with revenues. As for the balance sheet, it is affected when allowance method is applied on the basis of percentage of receivables, which implies that the company can estimate the percentage of its receivables on the ground of its past experience. This method provides reasonably accurate estimate of receivables’ realizable value.