Question

My question about the Allowance Method is why do you still estimate a total of the allowance of doubtful accounts when you are going to figure out who will not pay at the end anyway?

Answer 1

Allowance method is used in case of accrual system of accounting where bad debt expense is estimated based on the either credit sales or ageing of receivables. One of the reason for allowance method is conservative principle where any future losses or expenses are estimated by company for each year. Also the allowance method helps in recognizing the bad debt expense over the years which could be smaller amount and thus the trend in net income might be similar. However if bad debt expense is reported only in the year when customer does not pay then there is possibility of huge amount of bad debt expense and thus leading to loss or decrease in net income in a particular year. This expense would have actually belong to previous years for credit sales made in previous years. Also sudden recording of huge expense may increase the credit risk of company and thus it is better to estimate the expenses over the year. When actually the receivables are not collected then it can be written off from the allowance created. Instead of recording the expenses in later years, it is better to record in recent years. Also based on accrual system of accounting expenses for current year should be recorded in current year. Thus, allowance of doubtful accounts is used to avoid future risk for business.