The less likely customers are to pay, the larger the allowance needs to be. An allowance is an estimate that follows collectability, so older or riskier balances carry a higher percentage than recent ones.
This lesson, part of receivables and allowances, explains the reason behind the allowance calculation. You will be able to write a short, correct explanation as well as work out the figure.
Why does age change the estimate?
A debt that is ten days old is usually just waiting for the normal payment cycle. A debt that is three months old may mean a dispute or a customer in difficulty. The longer a balance is unpaid, the more doubt there is about whether it will ever be paid.
A business that wants to be prudent records lower profit now rather than overstate its assets. Prudence means not showing receivables as worth more than the business honestly expects to collect.
How to calculate from an ageing policy, step by step
- Read the supplied policy. It states a percentage for each age group.
- Take each age group’s balance from the question.
- Multiply each balance by its percentage.
- Add the results to find the allowance.
- Compare with the existing allowance and record the change, as in the earlier lesson.
Worked example
Pantai Timur Traders has the following receivables ageing at year end, with a policy set by the owner. The percentages are for this question only.
| Age of balance | Receivables (RM) | Policy | Allowance (RM) |
|---|---|---|---|
| Up to 30 days | 12,000 | 1% | 120 |
| 31 to 60 days | 6,000 | 5% | 300 |
| Over 60 days | 2,000 | 20% | 400 |
| Total | 20,000 | 820 |
Checks: the balances add to RM12,000 + RM6,000 + RM2,000 = RM20,000, and the allowances add to RM120 + RM300 + RM400 = RM820.
A flat 5% on RM20,000 would give RM1,000. The ageing method gives RM820 because most of the receivables are recent. The business’s older, riskier balances still carry the highest percentage, which is the point of the method.
A short written explanation: “The allowance is higher on older balances because the longer a debt is outstanding, the less likely it is to be collected. The business applies prudence by recording a larger estimated loss for these balances.”
The mistake to watch for
Many students write that the allowance is money the business has put aside.
Mistaken explanation: “The allowance is cash that the business keeps in a separate bank account in case customers do not pay.”
The student connected the word “allowance” with saving money.
The allowance is a bookkeeping estimate. No cash is moved, and the bank balance does not change. It is recorded as a credit balance that is deducted from receivables, and the matching debit is an expense that reduces profit.
Check yourself
1. An ageing policy gives 2% for RM8,000 of recent receivables and 25% for RM2,000 of overdue receivables. Find the allowance.
Show answer
2% of RM8,000 = RM160. 25% of RM2,000 = RM500. Total = RM160 + RM500 = RM660.
2. Overdue balances grow while total receivables stay the same. Does the allowance rise or fall, and why?
Show answer
It rises. Overdue balances carry a higher percentage because they are less likely to be collected, so a larger share of the total is estimated as lost.
3. True or false: recording an allowance reduces the bank balance.
Show answer
False. No cash moves. The entry reduces profit and the net value of receivables.
Where this leads next
You now have every skill in the cluster, so test them together on the receivables and allowances practice set. If you need to rehearse the double entry again, return to recording an irrecoverable amount.
Students who can calculate but struggle to explain often benefit from talking an answer aloud and refining it. A teacher in online one-to-one Accounting tuition can do that with you.