The term allowance in “allowance method” refers to the estimated amount of accounts receivable out of the total credit sales that a company believes will not be collected and thus should be recorded as a bad debt expense at the time of the loss estimation. Companies make the estimation of allowance for bad debt following credit sales, based on past experience, current market conditions and an analysis of the outstanding accounts receivable. The allowance is a negative account to accounts receivable and thus serves as a reduction to the amount of total accounts receivable.
The direct method specifically refers to the direct write-off out of the total accounts receivable when certain accounts have been deemed uncollectible. The amount of a write-off for the uncollectible accounts receivable is thus a bad debt expense to a company. Under the direct method, at the time of the credit sales, a company assumes that all accounts receivable are in good standing and reports accounts receivable in their full sales value. However, upon a write-off in the future, the loss of accounts receivable, or the incurring of a bad debt expense, is not the result of the sales in the later period when the write-off occurs, but rather from the current credit sales.
The use of the allowance method is intended to match a bad debt expense with credit sales of the same period, from which a loss of accounts receivable occurs in the future. Without reporting a bad debt expense in the period in which related credit sales are made, companies understate costs that are used to generate the credit-sales-related revenue when they fail to collect a portion of the credit sales in cash in a future period. In the meantime, companies overstate the bad debt expense for the future period in which the loss of accounts receivable actually occurs.
The allowance method is also used to achieve a proper carrying value for accounts receivable. Recording an allowance for expected uncollectible accounts receivable results in the outstanding accounts receivable being stated at their estimated realizable value, which is the amount of cash a company is likely to collect from accounts receivable. The allowance method is considered a standard GAAP method, while the direct method is appropriate only when the amount uncollectible is immaterial. GAAP requires that assets, including accounts receivable, be revalued and reduced by the amount of probable losses that can be reasonably estimated, when companies believe that an asset has diminished in value.