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What is Allowance in Accounting?

Instructor: Mark Koscinski

Mark has a doctorate from Drew University and teaches accounting classes. He is a writer, editor and has experience in public and private accounting.

In this lesson, you will learn how the accounting profession defines the term allowance. You will also learn about common allowances used on financial statements and the two cornerstones of generally accepted accounting principles.

Estimates in Accounting

Many people believe accounting is a very precise science that records financial transactions with pinpoint accuracy. In reality, modern accounting is an art frequently requiring the use of estimates to complete financial statements. Accounting estimates are used when financial statements must be published prior to the availability of final information regarding individual transactions or processes.

Suppose a company has a ninety-day sales return policy. The company must publish its financial information at the end of the month or quarterly--far sooner than ninety days. It cannot wait to see what the actual returns will be. The company will estimate its sales returns and then establish an allowance for returns. This is just one of several common allowance accounts used in accounting.

Generally Accepted Accounting Principles

Allowances are the result of two principles in accounting-- the matching principle and the conservatism principle. The matching principle, also known as the expense recognition principle, requires all expenses incurred when generating revenue be accounted for when revenue is recorded in the company's income statement. In other words, any loss or expense that the company incurs in conjunction with the sale must be accounted for in the same period as the sale itself. Generally accepted accounting principles also require that no asset can be carried on the financial statement at an inflated value. This is known as the principle of conservatism.

While these concepts may seem simple, their implementation can often be very complex. Returning to our example above, the company knows it will have merchandise returns based on its operating history. Therefore, it must provide for these potential returns in the period the sale was recorded. The company must have a systematic and rational method of estimating those returns currently and account for them accordingly. One way to account for those returns would be to use an allowance.

Allowances

The word 'allowance' has several definitions in the business world. We will focus on the accounting definition in this section. An allowance is a balance sheet contra-account linked with another account that has an opposite value to that account, and is reported as a subtraction from the linked account's balance. Returning to our example, let's suppose our company sells $100,000 in revenue. It must still account for the merchandise that might be returned. It does so by creating an allowance that estimates the merchandise returned. If it estimates that $10,000 of merchandise will be returned, then its net revenue will be $90,000 ($100,000-$10,000).

Other examples can be found in the accounting of fixed assets. For example, fixed assets have a debit balance, while the allowance for accumulated depreciation has a credit balance. They are reported together, with the resultant combination being net fixed assets (fixed assets less the allowance for accumulated depreciation).

Another term often used interchangeably with allowance is reserve. An allowance is established or replenished by a provision, an estimated expense.

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