Allowance definition
/What is an Allowance in Accounting?
An allowance is a reserve that is set aside in the expectation of expenses that will be incurred at a future date. The creation of a reserve essentially accelerates the recognition of an expense into the current period from the later period in which it would otherwise have been recognized. The intent of a reserve is to match expenses with the sales transactions with which they are associated. For example:
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An allowance is created for bad debts that are expected to arise from invoices sent to customers.
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An allowance is created for sales returns that are expected from current shipments to customers.
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An allowance is created for warranty claims expected from current shipments to customers.
Example of an Allowance in Accounting
The controller of Games Corporation has noticed a spike in the returns of several of its board games, with the complaint that the boards are delaminating. Further investigation reveals that the company received a bad batch of cardboard from a supplier, so it must be presumed that the entire batch will be returned by customers. This will result in a maximum of $200,000 of games being returned. Accordingly, the controller sets up a $200,000 allowance for warranty claims.
A few months later, the controller notes that only $50,000 of warranty claims were made in relation to the delamination problem, and that the warranty period has expired for these games. Accordingly, he reverses the remaining $150,000 of the allowance, since it will never be used.
What is an Allowance in Sales?
The "allowance" term can also be used from the perspective of a customer order, where the sales staff gives an allowance that is essentially a price reduction, perhaps based on year-to-date order volume, or because an order is being placed within a time period designated as being subject to a discount.
What is an Allowance in Employee Travel?
The allowance concept can also apply to per diem travel and entertainment arrangements, where employees are paid a certain amount per day for their travel expenses, irrespective of the actual amount incurred. This practice can give rise to extreme frugality by employees, in order to earn a profit on the per diem amounts paid to them.