Question

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

Under the direct write off method, a company waits for an account to actually turn uncollectible or bad , after which it is written off and the amount is recorded as bad debt expense. This naturally follows that the accounts receivable are reported at their original amounts on the balance sheet,giving a misleading picture as if all can be collected as cash .Hence they are overstated as also the profits as per the income statement as no bad debt expense is recorded. Also the matching principle of accounting, the corner-stone of accrual accounting is not met, as the expense relating to the sales revenue earned are not recorded in the most relevant period but deferred till the company comes to know of the debt turning bad.

In contrast,allowance method is highly preferred as under this method,the accounts receivable appears on the balance sheet with a contra account ,viz.the allowance for doubtful accounts account.Here,the net amount of the accounts receivable will be the realisable and much lower as also closer to the cash amount that will actually be collected. Bad debt expense is recorded at the time that the above allowance for doubtful accounts is created . Also the matching principle of accrual accounting is taken care of.

That said about both the systems,“when they occur” means when the company comes to know for sure about the possibility of a quantum of credit sales to turn bad-- the company following the allowance method must debit bad debt expense and credit the allowance for doubtful debt account.

So, instead of reversing the credit sales entry as given in the question, Mark should pass the follwing journal entries as below -

Date	Journal entry	Dr.	Cr.
1	Bad debt expense A/c	$   3,105
	To Allowance for doubtful A/c		$   3,105
	(Being balance in the allowance account raised)
1	Allowance for doubtful A/c	$   3,905
	To Accounts receivable A/c		$   3,905
	(Being relevant receivables written-off)