Question

CASE STUDY 7 – RECEIVABLES

Max is very happy with the work you have done in tidying up his inventory recording and valuation systems and is quite confident that his reports will now give him more useful information and provide him with a truer picture of the position and performance of the business.

However, Max is now concerned that some of the other areas of his business could need a review given some the problems found with the recording of inventory. Max has explained to you that he is still a little confused about the entries required when he was considering purchasing “Ray’s Motors”. In particular Max is still unsure about the discrepancy between the fair value of accounts receivable and their historic cost and why the fair value was not recorded in a similar way to the other assets.

Max is also concerned that his accounts receivable have become a significant proportion of his assets. Prior to expanding his business operations Max had been owed no more than a few hundred dollars. At present his accounts receivable figure totals $26,500 and this increased to $56,419 once Max purchased the group of assets and started producing his DIY Clean Air Turbo System. Max has been able to ascertain that at the beginning of the financial year the fair value of his accounts receivable was $52,205.  

Max received a letter some months ago stating that one of his debtors would not be able to pay their debts. Max filed the letter as he was unsure whether an accounting entry was required or not and as no cash was going to be received that it would have little impact on the accounting system. You have explained to Max the importance of recording all relevant information in an accrual accounting system and that bad debts should be recorded when they occur.

Taking this advice on board Max went away and reviewed some of his old accounting notes and produced the following General Journal entry, the entry date is based on the day Max received the letter.

17 April           Bad Debts Expense                             3,550

                        GST                                                       355

                                    Accounts Receivable                          3,905

            Required

1. Explain to Max that he has misunderstood what you meant when you told him to record bad debts “when they occur” and why his entry does not fit with the allowance method of accounting for bad debts that he is currently using. (Note – In Case Study 2 you created an Allowance for Doubtful Debts account with a $800 balance, Max has not touched this account since). In your explanation point out to Max the differences between the direct write-off and allowance methods and why the allowance method is preferred.

Answer 1

It is a fact that there are two different methods following by accountants for bad debt accounting. For creating a most realistic accounting method which is generally accepted by investors and banks etc, allowance method of bad debt accounting is good. As we know that receivable amount of the Company has a connection with sales of any given period. Hence the allowance method of bad debts accounting by creating bad debt allowance will help to showcase the most reliable financial reports. At the same time the write off of bad debt is happening when it happens only till that it is showing in the books as reserve, and the write off entry affects only the balance sheet at that time. No effects is showing in P&L during write off time as it already been covered through adjusting entries during the concerned accounting year of the relevant sales. And we have already started following allowance method for bad debts accounting and created allowance in the books.

Also please note the differences of both system. Under direct write off method, the write off is happening when the accountant realize that it is bad debts. However it is not in the same year in which the concerned sales happened. Hence the matching principle is violated in direct write off method. Also it is against prudence concept or the conservatism principle. (revenue shall only be recognized when it is certain and expense shall be booked when it is probable). But under allowance method a suitable allowance is created (based on receivable or sales) and accounted. Hence the profit / loss of the firm is most reliably and accurately can showcase.

In both system accounting entries are also different. Under direct method it is a simple entry as under for the written off amount:-

Bad Debt Expense A/c Dr

Account Receivable A/c. Cr.

However in allowance method, a proper allowance based on receivable or sales is created and accounted and the accounting effect will be in P&L. Later the write-off when happened the entry effect will be happening in balance sheet only. Following are the journal entries:

Allowance for Doubtful debts Dr

Accounts Receivable A/c Cr.

(written off time)

Bad Debts Expense A/c Dr.

Allowance for Doubtful debts Cr.

(To record Estimate /Allowance)