A valuation account is a balance sheet account used together with a related account to adjust that account's carrying amount without changing the original recorded figure. The best-known examples are accumulated depreciation, which reduces the cost of plant assets, and the allowance for doubtful accounts, which reduces receivables to the amount the business expects to collect.
Most valuation accounts are a contra account, carrying a balance opposite to the account they adjust. A few are an adjunct account, which adds to the related balance, such as Premium on Bonds Payable. Keeping the original amount in one account and the adjustment in another preserves both pieces of information: what was paid or owed, and the current estimate of its value. A valuation account means nothing on its own and is always reported with its partner account.
Valuation accounts in plain terms
Imagine keeping the original price tag of a car you bought, and keeping a separate running note of how much value it has lost each year. Anyone can read the tag to see what it cost and read the note to see how much has worn away. Subtracting one from the other gives today's value.
Accountants work the same way. Instead of rubbing out the original cost and writing a new figure each year, they leave the cost untouched and build up the adjustment in a second account. This keeps a clear history and makes it easy to change the estimate later without losing track of where the numbers came from.
Common valuation accounts
- Accumulated depreciation. Reduces buildings, equipment and other plant assets to their carrying value.
- Allowance for doubtful accounts. Reduces accounts receivable to the amount expected to be collected. Under the current expected credit loss model in ASC 326, US companies generally call it the allowance for credit losses.
- Inventory allowance. An allowance to reduce inventory to net realizable value records a write-down while keeping inventory cost records intact.
- Bond discount and premium. Discount on Bonds Payable reduces, and premium on bonds payable increases, the face value of bonds to their carrying amount.
- Deferred tax valuation allowance. Reduces a deferred tax asset when it is more likely than not, meaning a likelihood above 50 percent, that some of the tax benefit will not be realized.
How a valuation account works
A company has accounts receivable of $250,000 at year-end and estimates that $9,000 will not be collected. It debits bad debts expense $9,000 and credits the Allowance for Doubtful Accounts $9,000. The balance sheet shows receivables of $250,000 less an allowance of $9,000, a net amount of $241,000.
Early the next year, a customer who owes $1,200 goes out of business. The company debits the allowance $1,200 and credits Accounts Receivable $1,200. Receivables fall to $248,800 and the allowance to $7,800, so the net amount stays at $241,000. The expense was recognized when the estimate was made, not when the specific account failed.
Why separate accounts are used
- Unknown targets. At year-end the company does not yet know which customers will fail to pay, so it cannot reduce individual customer balances in the subsidiary ledger. The allowance holds the estimate until specific accounts are identified.
- Preserved cost. Plant assets stay at original cost, which is needed for disclosures, for calculating gains and losses on disposal and for tax records.
- Revisable estimates. Depreciation, credit losses and fair value adjustments can be updated each period without restating the original transaction.
US GAAP requires accumulated depreciation and allowances to be disclosed, either on the face of the balance sheet or in the notes to the financial statements.
Valuation accounts in financial analysis
Because valuation accounts are built from estimates, analysts watch them closely. A shrinking allowance for doubtful accounts while receivables grow can signal that a company is flattering its profit by under-reserving. In a 1998 speech known as The Numbers Game, Arthur Levitt, then chairman of the SEC, criticized companies for building excessive reserves in good years and releasing them later to smooth earnings, a practice often called cookie-jar accounting. Comparing allowance balances with receivables, write-offs and sales over several years helps users judge whether the estimates are reasonable.