Question

12. Allowance for doubtful accounts. When a company has a policy of making sales for which credit is extended, it is reasonable to expect a portion of those sales to be uncollectible. As a result of this, a company must recognize bad debt expense. There are basically two methods of recognizing bad debt expense: (1) direct write-off method, and (2) allowance method. Instructions Describe fully both the direct write-off method and the allowance method of recognizing bad debt expense. Discuss the reasons why one of the above methods is preferable to the other and (a) (b) the reasons why the other method is not usually in accordance with generally accepted accounting principles.

Answer 1

1. Direct write off: Under the direct write off method, the bad debt expense is written to the accounts receivable account as and when the bad debt expense has been ascertained.

Allowance method :In the allowance method, an allowance is made for the bad debts ascertained against the allowance for doubtful debts account. At the end of the accounting period, the actual bad debts expense is adjusted with the allowance for doubtful accounts created earlier for each individual accounts receivable.

Example:

MR X owes $500 and has been declared insolvent. Entries:

	Direct write off				Allowance method
	Account Titles	Debit	Credit		Account Titles	Debit	Credit
Initial recognition	Bad debt expense	500			Allowance for doubtful accounts	500
	Accounts receivable - X		500		Accounts receivable - X		500
Adjusting entry	Nil				Bad debt expense	500
					Allowance for doubtful accounts		500

2. The direct method is likely to violate the GAAP principle of matching principle of matching revenues with expenses since they are recognized as when the bad debts incur. For instance a sale that has been made in the previous year may turn out to be a bad debt this accounting year and if expense is recognized in the current year it does not comply with the GAAP rules. The allowance method is preferred over the direct method since it has improved matching of expenses with revenues as an estimate for bad debts for sales is made at the end of the accounting year and the bad debts relating to a particular period are adjusted against the estimated allowance.