Question

The owners have approached you, the businesses accountant and asked if, for the financial year ending 30 June 2021, you would change to the direct write-off method for recording bad debts. How does changing the measurement of bad debts from the allowance method to the direct write-off method influence the usefulness of financial information? Ensure you reference the fundamental qualitative characteristics of information prescribed by the Conceptual Framework for Financial Reporting in your response.

Answer 1

There are 2 ways to account for bad debt. The fundamental difference between the 2 methods is in timing difference of bad debts expense recognition and accounting principles applied for accounting bad debt expense. Hence both methods are not same and the recommended method for accounting is allowance method. A direct method of write off is not in accordance with conceptual framework for financial reporting and change to direct method of write off is not recommended compared to allowance method.

Direct write-off method: This method accounts for bad debts based on actual bad debts generated in business that is when customer is unable to pay and it is confirmed that customer dues is a bad debt For example: A court order is passed for customer insolvency. In this case the bad debts are debited to Income statement and credit is given to Accounts receivable. This method is not in accordance with accrual concept and matching concept since bad debts are not accrued for each period and bad debts of different period can be charged to sales of different period.

Allowance method: This method considers the percentage of allowance on Accounts receivable balance during the period and accounting is done through an Allowance for uncollectible receivables. The bad expense is calculated as percentage of closing Accounts receivable balance. A bad debts expense is debited and credit is given to allowance for uncollectible receivables. Only when the customer dues are confirmed as bad debts it is debited to Allowance for uncollectible receivables account and credit is given to accounts receivable account. This method is in accordance with accrual concept and matching concept since bad debts are accrued in the period in which sales take place and bad debts expense match the sales recognised in the period.

Allowance method preferred over direct method as per conceptual framework for Financial Reporting

The allowance method is recommended since it gives true and fair view of financial statements. It is in line with accrual concept and matching concept of financial reporting framework