Question

Discuss the reasons why we need to have methods of anticipating the amount customers will fail to pay of Accounts Receivable. (Allowance method and Percent of Sales method)

Answer 1

We need to anticipate the amount customers will fail to pay of Accounts receivable (amount of likely bad debts expense) so that the income for a period can be correctly ascertained as per the accrual/matching principle.

In the alternative, one has to resort to the 'direct write off' method, under which, debts are written off as 'bad debts expense', as and when they become bad. Such a treatment will mean that, debts may not be written off as bad in the same period in which the corresponding sale occurs. This will violate the 'matching principle' of accounting which, says that all expenses that are incurred for earning the revenue for a period, are to be accounted in the same period. This needs to be done at least on an estimated basis. The allowance method and the percent of sales method intend to achieve such an end.

The percent of sales method seeks to estimate the likely bad debts based on past experience. The estimate is usually expressed as a % of credit sales for the period and a provision is made to that extent each period. When bad debts occur those amounts are adjusted against the provision.