Allowance of Prices Falling
When finishing the inventory at the end of the year, this inventory will be pricing by cost whether by FIFO, LIFO or Weighted Average according to the method that company follows.
The principle of caution:
The principle of caution is considered one of the most important accounting principles, this principle works as follows:
If there is an expected profit, it should be skipped until being achieved, whereas there is an expected loss, an allowance should be created for it immediately.
This principle is applied to all current assets (goods - Debtors - Notes Receivable - Financial Notes).
Allowance definition and the importance of its creation:
Allowance is reserve a part of the incomes of the financial period to meet the expected decrease in an asset or the possible increase in the value of commitment.
One of the examples of the allowances is the allowance of the doubtful debts, which is to face what a facility may face of burden when debit execution during the next financial period, Alagio to face what a facility may suffer of expenses when discount the notes receivable during the next finical period.
The allowance of prices dropping of the financial notes that will be to face what a facility may suffer from burdens when the descent of the market value for financial notes under its cost.
From the previous definition of the allowance, it\'s clear that the allowance is being created for the following reasons:
- To meet the decrease in the value of the fixed assets (Depreciation).
- To meet the renew of the fixed assets.
- To meet the decrease that will happen for sure in the value of the asset, which can be recognized and cannot determine its accurate value (for example: the allowance of bad debits).
- To meet the decrease that is most likely happen in the future in the value of the asset (for example: the allowance of the doubtful debts, the allowance of the decrease of the goods prices, the allowance of the decrease of the financial notes).
- To meet certain commitments that can be recognized and cannot determine its accurate value (like taxes).
- To meet a commitment that is most likely happened (like the allowance of compensation).
Types of Allowances:
1- Allowance of falling of goods prices:
The principle of caution will be applied on the ending inventory, so at the end of the financial period, there will be a comparison between the cost of the securities and their market value, so here are the following situations:
A- The situation where the market price equals to the cost price:
In this situation, there is no expected profit or expected loss, so the goods will be shown in the budget with the cost price.
B- The situation where the market price is greater than the cost price:
In this situation, there is an expected profit that will be left until it is being achieved, and the goods will be shown in the budget as well with the cost price.
C- The situation where the cost price is greater than the market price:
In this situation, there is an expected loss with the amount of the difference.
If the cost of goods was 100000 and their market price is 80000, the expected loss will be 20000, and an allowance will be created for it immediately, which called allowance of price falling of goods. This allowance will be shown as a subtracted from the asset cost in the budget as the following:
An amount of money will appear on the opposite to the allowance with the expenses in profit and loss account or the income statement with expenses, which called expense of goods prices falling.
But we should be cautious if a previous allowance is existed, it should be compared with the wanted allowance and increase or decrease it according to the situation.
2- The allowance of the doubtful debts:
It happens a lot in the business that the facility could not collect its own debts, in the situation we call it bad debts, and we always expect bad debts at the end of the financial period which occurs in the next period, this debt is considered an expected loss, so an allowance will be created which called doubtful debts.
The doubtful debts is estimated according to a specific percentage of debtors balance which appears on the Trial Balance in the end of the financial period after the subtraction of the bad debts when stocktaking, then comparing the amount of the doubtful debts with the balance of the transferred allowance from the previous period, the balance of the allowance will be increased or decreased with the difference.
The allowance appears as subtracted from the debtors balance in the budget as the following:
Note that the balance of the debts that appears on the budget is the balance after subtraction the bad debts that happened when stocktaking.
3- The Allowance of أجيو
This allowance is being created in order to face the possibility of that the facility is discounting the commercial papers in the bank before maturity date, in case it needs cash.
The expenses of discounting the notes receivable is being estimated according to the interest of the period from the date of preparing the financial statements until the maturity date of the notes receivable.
To make it easy for the calculations, the average of the maturity date is being used to get the interest rate on all of the commercial papers.
This allowance is used to cover the expenses of discounting the commercial papers that really happen during the financial period.
The allowance of discounting of the notes receivable appears as subtracted from the balance of the notes receivable appears account next to the assets in the budget as the following:
Of course we should compare the required allowance with the previously existed one, and increase or decrease it.
4- The allowance of falling of the financial papers prices:
The finical papers rise as short term investments on the base of the cost, in case of decreasing in its market value under the cost, it will be an allowance of prices falling of the financial papers (or investments) in the difference.
This allowance is used to meet the losses resulting from the selling of the financial papers with a lower price than its cost.
But if they\'re being sold with a higher price than its cost, the allowance will be closed by transferring its balance to the incomes in the income statement or by calculating the profits and losses.
The allowance of the falling prices of the financial papers will appear as subtracted from the balance of the financial papers account next to the assets in the budget.
The accounting processing of the allowances:
The adjusting entries of inventory that is being created in the end of the financial period when creating a new allowance or increasing the value of the current allowance as the following:
When the previously existed allowance is greater than the allowance which is required to be created, the allowance is being decreased, and the increase will be transferred to the profits and losses or profits statement (income) by the following bond:
Proofing the bad debts:
When collecting one of the debts become impossible, the debt becomes bad debt, thus, it is a happened loss, so it should be proofed and decrease the debtors balance, by the following bond:
Sometimes the customer whom his debt is being a bad debt may refund to the facility in a next financial period, in this situation, a reversed bond will be made to the previous bad debt, then make another bond to collect this bond. So bonds will be as follows:
The accounts of the expenses of the doubtful debts, expenses of Alagio, expenses of prices falling of goods and expenses of prices falling of the financial papers will appear within the current expenses items in the income statement. Whereas the allowances accounts are considered accounts in face to specific assets that appear in the balance sheet subtracted from the account balances of these assets.