Question

Using textbook

Title	Introductory Financial Accounting for Business
Author	Edmonds, Christopher T.
ISBN	978-1-260-81444-6
Publisher	McGraw-Hill Education
Publication Date	January

According to GAAP, uncollectible receivables must be estimated and recorded as an expense in the period in which the corresponding revenue is earned. This ensures compliance with the matching principle.

(1) Compare and contrast the percent of revenue method and the percent of receivables method.

(2) Why would a financial manager or analyst be concerned if the Allowance for Doubtful Accounts balance increased or decreased significantly?

Answer 1

Solution

1.Difference between the percent of revenue method and the percent of receivables method.

Percent of Receivables Method

a) It is used to derive the bad debt percentage that a business expects to experience.
b) Calculation is based on receivable amount.
c) It helps to account for actual and expected bad debts over an accounting period through financial statements.
d) This method gives more holistic view of your company’s bad debt as it considers previous year’s balances as well as current year receivables balances as well.

Percent of Revenue Method
a) It estimates the amount of bad debt expense a company will incur based on the amount of sales it makes on credit.
b) Calculation is based on sales amount.
c) It helps companies to account for project revenues ie, when to recognize income from a project.
d) It gives less holistic view of your company’s bad debt as it considers only the current year’s bad debt.

2.Allowance for Doubtful Accounts and its impact

a)When an allowance for doubtful accounts entry is passed,it implies that some customers won’t pay you the money they owe.
i) When customers don’t pay you, your bad debts expenses account increases.
ii) It,thereby, decreases the profitability of the business and
iii) Also affecting the financial position of the business enterprise.

b)When the Allowance for Doubtful Accounts increases
i) Reduces the profitability of the business.
ii) It decreases the amount of accounts receivables.
iii) It affects the operating activity and revenue generated from operations of the business.
iv) It also affects liquidity of the business because there is no inflow of cash.
v) It enhances the high risk of bad debts.

c)When the Allowance for Doubtful Accounts decreases
i) It Improves the profitability of the business.
ii) The amount of accounts receivables also increases.
iii) It boosts up the operarting activity and revenue generated from operations of the business.
iv) It improves liquidity of the business and thereby assist in meeting the working capital requirements.
v) Risk of bad debts reduces,thus resulting in good debts.

The following are the reasons why financial manager or analyst are concerned if the Allowance for Doubtful Accounts balance increased or decreased significantly.
The above points clearly indicates the significance of the Allowance for Doubtful Accounts in the financial reports of a company.