Valuation allowance is set aside for specific purposes, such as loss on investments, uncollectible accounts, and depreciation for fixed assets. Accountants use a contra account to adjust the historical value of an item and estimate its current fair value. Different valuation methods are used for different items, such as sales percentage or accounts receivable percentage for accounts receivable. National accounting standards require accountants to make proper valuation allowances for assets.
A valuation allowance represents funds set aside for a specific purpose. Among the most common reasons for this provision include a loss on investments, estimated amounts for uncollectible accounts, and depreciation for fixed assets. Accountants often post a valuation allowance on a contra account. A contra account falls into the asset account group and resides on a company’s balance sheet. The difference with a contra account is that it has a natural credit balance, which is the opposite of regular asset accounts.
Companies make a valuation estimate to adjust the historical value of an item as recorded in the company’s ledger. A contra account is related to an asset account and generally has an account number close to the original. Together, the original asset account with a debit balance will be offset against the contra account with a credit balance. The difference represents the actual value of the item at a current estimate of fair value. Each asset item has its own contra account for this process.
Accounts receivable is a common example of a valuation estimate. A business sells goods or services on credit, allowing customers to pay bills over time. Many companies allow customers 30 days to pay off their open accounts receivable balance. Accountants estimate how many open accounts receivable will remain uncollected from customers who do not pay their bills. Accountants make an allocation using one of two methods to create this figure.
Sales percentage or accounts receivable percentage are two common valuation allocation methods used for accounts receivable. The first method requires accountants to review past credit sales to determine how many of them were cancelled. The accounts receivable percentage method is similar; Accountants look at previous receivables written off and create a percentage to apply to current receivables. The bad debt percentage, applied to current open account receivables, indicates the valuation estimate for bad debt. Accountants post this figure in a bad debt allowance account, which is a contra asset that nets against current accounts receivable.
Valuation methods for other items, particularly assets, work on a very similar method. Accountants must find the current value of items through estimates or by looking at the current market price of the items. In most cases, items lose value and need adjustment, so a business represents its true financial value. National accounting standards often call this method of market accounting or fair value accounting. Accountants must stay within these guidelines to ensure that they make the proper valuation allowance for assets.
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