Question

You have been hired as a consultant by a parts manufacturing firm to provide advice as to the proper accounting methods the company should use in some key areas. In the area of receivables, the company president does not understand your recommendation to use the allowance method for uncollectible accounts. She stated, “Financial statements should be based on objective data rather than the guesswork required for the allowance method. Besides, since my uncollectibles are fairly constant from period to period, with significant variations occurring infrequently, the direct write-off method is just as good as the allowance method.”.  

Minum of 300 words.

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 Percentage of 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. Accounts receivable are shown as net in Balance sheet. There is no separate account used for bad debts accounting like allowance account. 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.

Percentage of 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. The provision for doubtful debts is a contra asset account with credit balance. It is deducted from Accounts receivable balance and net balance of Accounts receivable is shown in Balance sheet. 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.

Need for establishing differences between two methods

The direct write off method considers bad debts only when the dues cannot be recovered and hence it is not in line with accrual concept and matching concept because bad debts are not accounted as per sales and bad debts of different period sales can be debited in current period.

The percentage of allowance method is recommended since it gives provision for bad debts during the sales period as per accrual method and matches the bad debts expense to the sales period.