Question

Assume that XYZ company was started a year ago. As they are trying to figure out how to account for the uncollectible accounts, they are unsure of which method to use. If you recall in your principles class, it was broken down in to the Allowance Method and the Direct Write-Off Method. This book breaks the Allowance Method into two areas: 1. The sales revenue approach; and 2. The gross accounts receivable approach. There are not sure which method to use: 1. The sales revenue approach; 2. The gross accounts receivable approach; or 3. The direct write off method approach.

You have been hired to answer these specific questions: 1. Explain to them the difference among these three methods and which method you recommend and explain specifically why you would recommend that method. 2. Discuss the importance of making sure the accounts receivable reflects the correct balance and what the net realizable value is.

Answer 1

1.

1. The sales revenue approach: Under the sales revenue approach of accounting for uncollectible accounts, the bad debts or uncollectible accounts are estimated as a percentage of the net credit sales during the period. Under this approach, the existing balance in the allowance for uncollectible accounts is not considered while recording the bad debt expense for the period. The advantages of the sales revenue approach are its simplicity and that it results in very good matching of the bad debts expense with the sales revenue during the period. However, the main disadvantage of the sales revenue approach is that no consideration is given to the balance in the allowance account which is used to arrive at the net realizable value of accounts receivable in the balance sheet due to which the net realizable value may not be very meaningful.

2. The gross accounts receivable approach: Under the gross accounts receivable approach, the uncollectible accounts are estimated as a percentage of the accounts receivable balance at the end of the period. Under this approach, the bad debt expense is calculated as a balancing amount after considering the beginning and ending balances in the allowance for uncollectible accounts and the bad debts written off if any during the period. The matching of the bad debts expense with the sales revenue may not be as good under this approach as it is under the sales revenue approach however, it results in a more meaningful net realizable value of accounts receivable.

3. Direct write-off method approach: Under the direct write-off method, the bad debt expense is recorded when an account receivable is determined to be bad and uncollectible and not as estimated under the earlier discussed two approaches.

The direct write-off method is prohibited under the GAAP since it violates the accounting principle of matching expenses to related revenues in the same accounting period. However, the direct write-off method may only be used when the amount of the bad debt expense is so small that it is immaterial to the entity.

Recommendation: The gross accounts receivable approach is the recommended method since it results in a more meaningful net realizable value of the accounts receivable.

2.

An entity is required to report its accounts receivable based on the accounting principle of conservatism. It must therefore estimate the net realizable value or the amount that it expects to collect against the total accounts receivable and report its accounts receivable in the balance sheet at such value.

The net realizable value of accounts receivable is the estimated amount expected to be collected against the accounts receivable.

Net realizable value of Accounts Receivable = Total Accounts Receivable – Allowance for Doubtful Accounts