Question

Your friend owns a business that offers customers credit on their purchases, but she/he has never used any of the generally accepted allowance methods to calculate and record bad debt expense. For this discussion, prepare a recommendation for the business as follows:

Review the generally accepted allowance methods and determine which one you believe is the best method.
Prepare a summary of the method you selected that justifies why you believe it is the best method

Answer 1

There are basically two generally accepted allowance methods for recording bad debt expense in the books of accounts. These methods are percent of sales method and analysis of receivables method. Both these methods use estimation as the basis to calculate the bad debt expense. However, the focus of each method is different.

Under percent of sales method, the company estimates the amount of bad debt expense is estimated on the basis of sales (net sales) at the end of each accounting period. The available balance in the allowance for uncollectible/doubtful accounts is thereafter adjusted with the amount (of bad debt expense) so estimated. For Instance, let us assume that the net credit sales of Company A for the year is $200,000 and the company estimates that 2% of it is uncollectible. The current balance in allowance for doubtful accounts is $500 credit. At the end of the year this credit balance will be increased by the amount of bad debt expense. Therefore, the balance in the allowance account at the end of the year after this adjustment will be $4,500 (4,000 + 500). It can be concluded that here the focus is on bad debt expense and therefore, the impact is on the income statement. The entry to record this adjustment is provided as below:

Date	Account Titles	Debit	Credit
31. Dec	Bad Debt Expense (200,000*2%)	$4,000
	Allowance for Doubtful Accounts		$4,000

Under analysis of receivables method, the focus is on the net realizable value of accounts receivables and therefore, the impact is on the balance sheet. Here, the company estimates the amount of uncollectible accounts by segregating the accounts receivables on the basis of their age and applying a different percentage to different age groups. For Instance, the company may consider a percentage of 2% of accounts receivables (as uncollectible) falling within the age group of 1 to 30 days, while it may apply a percentage of 15% of accounts receivables (as uncollectible) falling within the age group of 60 to 90 days.

Once, the company has estimated the uncollectible amount (by adding up individual totals for different age groups), it records the bad debt expense by adjusting the available balance in the allowance account. For Instance, let us assume that the net credit sales of Company A for the year is $200,000 and the total amount estimated to be uncollectible (on the basis of percentages applied to different age groups) is $1,000. The current balance in allowance for doubtful accounts is $250 credit. At the end of the year the total amount in the allowance account would be recorded at $1,000 only (by recording a credit of $750). The bad debt expense would get adjusted with amount of current balance in the allowance account. The entry to record this adjustment is provided as below:

Date	Account Titles	Debit	Credit
31. Dec	Bad Debt Expense (1,000 - 250)	$750
	Allowance for Doubtful Accounts		$750

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Based on the above comparison, I would prefer the percent of sales method to start with as it is comparatively easier and uses the concept of matching expense with revenues by focusing on the bad debt expense and consequently the income statement. Estimating uncollectible accounts by applying different percentages on the basis of age of receivables may be more complex and time consuming.