Allowances are future expenses that a business anticipates against certain accounts. They can also refer to benefits received by employees as part of their remuneration packages.
Businesses must ensure a uniform and transparent method to record these allowances and reconcile them as and when actual transactions occur in the future.
Let’s discuss what is an allowance in accounting, what are the different types of allowances, and how are they recorded.
An allowance in accounting terms refers to the reserve amount set aside for anticipated expenses in the future by a business.
It can also be reserved for an expected loss of revenue, loss of receivables, and loss of value in assets held by a business. It is an estimated amount and it be fixed or variable depending on the type and purpose of the allowance.
In other accounting terms, an allowance also refers to the financial benefits offered by employers to their employees against specific activities.
These are called salary or benefit allowances. These benefits are usually fixed at a percentage of the basic or gross salary of an employee.
In sales terms, an allowance refers to the discount offered by a business to its customers against damaged or returned goods.
The most common use of the term allowance in accounting is for the amount reserved for future expenses.
The purpose of these allowances is to accelerate expense recognition and match the expenses arising in the coming periods with their relevant sales streams.
Taxable and non-taxable allowances vary for businesses and personal (or salaried) purposes.
For businesses, taxable allowances are any reserves set aside for specific future business activities because they cover some sort of expenses.
For instance, a business may set aside a bad debt allowance by anticipating a portion of unrecovered collectible debts outstanding.
Under the tax regulatory guidelines, if the business sets aside a reasonable amount matching its unrecovered debt history and current level of receivables, the bad debt allowance can be listed as an expense.
Similarly, when a business follows a policy of benefit allowances like medical, transportation, and dining allowances for its employees, these can be listed as expenses by the business.
However, most of these common allowances are taxable and cannot be used to avoid taxes.
Only specific government allowances like foreign services allowance, compensation to the judiciary, armed forces allowances in foreign territories, etc. are non-taxable income.
An individual may receive allowances from the employer. Therefore, the nature of allowances and their tax consequences vary for both parties.
Allowances Received by Individuals
Individuals usually receive benefit allowances in their salaries. These benefits are paid for additional tasks or as compensation by employers.
Any benefit allowance received by an individual is usually taxable income. For example, a transportation allowance received in the form of cash adds to the gross salary of an individual which is then calculated for income tax.
Allowances Issued by Businesses
Businesses issue benefits and accounting allowances. The benefit allowances are issued to employees as compensation or part of the employee remuneration packages.
Accounting allowances are issued to recover future expenses in specific categories. For example, an allowance for credit recoveries.
The first step in the accounting treatment for allowances is to establish the allowance rate or amount.
Individual benefit allowances can be set at a fixed percentage of gross salary or capped with a dollar amount per benefit transaction.
Similarly, business allowances can be established on a historical percentage, percentage of the account, or risk classification method.
The journal entry to record this transaction would be:
DR Expense Account
CR Allowance Expense Account
The second step is to record the initial allowance transaction for an account. This is an estimated amount and can be adjusted or written off later.
The next step is to adjust the allowance entries depending on how the actual transactions take place.
If the business wants to decrease the allowance expense account, then:
DR Allowance Expense Account
CR Expense Account
The accounting entries can be adjusted by increasing or decreasing the allowance account according to the actual transactions.
The final step in the accounting process is to write off or recover an allowance account. If the business fully recovers the allowance expense, it can be recovered.
The journal entry for the transaction will be:
DR Expense Account
CR Allowance Expense Account
CR Expense Account
A business can use separate journal entries for each type of expense account or combine them to create a single journal entry sequence.
Suppose a company ABC has an amount of $100,000 of accounts receivable less than 60 days and $120,000 of accounts receivable older than 60 days.
The company’s historical percentage records for accounts receivable suggest that 5% of receivables older than 60 days and 3% of receivables less than 60 days remain unrecovered.
Total Amount of Estimated Bad Debts =( 5% ✕ 120,000) + (3% ✕ 100,000)
Total Amount of Estimated Bad Debts = $9,000
The journal entry to record this initial bad debt allowance will be:
|Bad Debt Account||$9,000|
|Allowance Expense Account||$9,000|
Suppose the company receives an additional $2,000 later from these bad debts, then the adjusting entry for this transaction will be:
|Bad Debt Account|
A similar transaction can be recorded if and when the company fully recovers these bad debts.
Allowances can be categorized mainly into two categories for individuals and businesses.
Individual Allowance Types
Some of the commonly used benefit allowances received by individuals are discussed below.
- Housing Allowance
Employees receive this benefit amount when they relocate or have to work from specific locations beneficial for employers.
- Transportation Allowance
Employers have to provide means of transportation to their employees or pay them compensation if they manage their transportation themselves.
- Travel Allowance
A travel allowance is often paid for specific business tours carried out by specific employees. It is often paid as a lump sum amount rather than a percentage of the gross salary.
- Medical and Health Allowances
Most employers must comply with local and federal regulations by offering medical and health allowances to their benefits.
Often, these benefits come in the form of insurance.
- Entertainment Allowance
Similar to travel allowances; entertainment and dining allowances are offered to employees on business tours. Some companies do offer these allowances as part of the remuneration packages to their employees though.
Business Allowance Types
Some commonly used business allowances are discussed here.
- Bad Debt Allowance
This is a contra account created to offset bad debts for a business. It is an estimated amount of unrecoverable debts for a business.
- Sales Allowance
Sales allowances are issued to offset claims made by clients for damaged goods. It is often offered to regular clients as a discount on sales prices.
- Allowance for Credit Losses
If a lender has long outstanding loans and historical records suggest a portion of these loans will remain unrecovered, the lender can create a credit loss allowance.
- Warranty Claim Allowance
Similar to sales allowance, a warranty claim allowance is used to adjust the warranty claims by clients for damaged or faulty items.
- Tools and Equipment Allowance
This type of allowance is used internally for employees when an employer offers working tools and equipment to its employees and forecasts claims in the future.