Question

Compare and contrast the two methods for estimating bad debt expense. Explain which method do you think gives a better representation of current bad debts.

Answer 1

First method for estimation of bad debts is aging analysis. We separate all the debtors into the number of days since when they are outstanding. Like for example 0-30 days, 30-45 days, 45-60,60-90 days & so on. The general idea is that the longer a debt is outstanding the more chances of it going bad. So, on the basis of its past experiences, the company allocates a specifice percentage to each debtor age group like say 1% for 0-30 days, 2% for 30-45 days & so on. By doing this calculation, an organisation can arrive at the estimated bad debt figure.

Second method is the percent of sales method. In this method only credit sales is considered since it is the part which runs the risk of turning bad.A fixed porton of credit sales is estimated to be as bad debt ssay 1% or 2%. It is as simple as that.

I think that the first method gives a better representation of the bad debts since its underllying assumption holds true generally that older the debt gets, the lower its chances of it getting recovered. So assigning that portion of debt a higher risk than others gives a better estimate rather than assigning a fixed percentage to all credit sales.