Question

1. For company's that use the Allowance method, why do they calculate and journalize bad debts expense? (Hint: think about some of the GAAP principles learned in Chapter 1 and Chapter 3.)
2. In your opinion, what is the trickiest part of Chapter 8. Explain.

Answer 1

The company that uses the allowance method estimated a percentage of debts that are uncollectible based on past experiences. An estimate may be based on % credit sales, % accounts receivables or % past due collectibles. Allowance method follows matching principle of accounting by recognising bad debts in the same period as the sales to which receivables are related and hence they estimate, journalised and record bad debt expense. Bad debts expense are recognised early as they are probable and can be estimated fairly. An adjusting entry is passed at the end of accounting period to recognise estimated bad debts that relate to closing balance of receivables. There is no direct credit to receivables account as the amount is just as estimate of likely uncollected debts and actual defalut is unknown. Hence, it is a provision in the form of contra asset.

Hence, bad debts are calculated and recognised based on estimated under allowance method to follow the matching concept and recognition of contingent losses

The triciest part is the estimate of amount of allowance to be provisioned as contra-asset. There are various methods based on which the amount is estimated and to choose the most optimal method is tricky. As bad debts are expensed based on estimates there are chances the estimate may go wrong and it may happen that there are too high or too low uncollectibles requiring post period adjustments.