In: Accounting
Discuss the 2 different methods used to account for bad debts/uncollectible accounts by a company. Include both ways of calculating the entry needed using the allowance method. Show an example of the adjusting entry made under the allowance method, as well as write-offs under each method. Discuss which method is preferable under GAAP and why?
There are two methods to account for bad debt:
The bad debt expense calculation under the allowance method can be determined in a number of ways, such as:
No matter which calculation method is used, it must be updated in each successive month to incorporate any changes in the underlying receivable information.
The direct write off method is not the most theoretically correct way to recognize bad debt expense, since the expense is recognized several months later than the revenue associated with the initial sale, thereby separating elements of the same transaction into different time periods. The more correct approach is the allowance method, since a portion of all sales is reserved against as soon as revenue is recognized. In the latter case, revenues and related expenses appear in the same time period, so one can see the full impact of all sales on profits within the same accounting period.
The bad debt expense appears in a line item in the income statement, within the operating expenses section in the lower half of the statement.
As an example of the allowance method, XYZ Enterprises records $10,000,000 of credit sales in the most recent month. Historically, XYZ Enterprises usually experiences a bad debt percentage of 2%, so it records a bad debt expense of $ 200,000 with a debit to bad debt expense and a credit to the allowance for doubtful accounts. In the following months, an invoice for $ 40,000 is declared not collectible, so it is removed from the company's records with a debit of $ 40,000 to the allowance for doubtful accounts and a credit to accounts receivable.