Question

pick a method of accounting for bad debt. What do you like about it and why? give an example of a company where it makes sense to use that method? Why does it make sense?

Also give an example of a company where it makes sense to use Allowance method for bad debt? Why does it make sense?

Answer 1

There are two accounting approach to record a bad debt, which are direct write-off method and the allowance method. In the direct write-off method, the bad debt would be debited to expense when it is apparent that an invoice would not be paid. Direct charge off method for uncollectible will directly debits, or charges, an expense account when a bad debt is discovered. On contrary under allowance method, an estimation of the future amount of bad debt would be debited to a reserve account as soon as a sale is made. Under the allowance method in accounting for accounts receivable the bad debt expense is an estimate that is based on historical and prospective information

I prefer the allowance method over direct write-off method. The reason is that direct write-off method is not a perfect approach as the charge to expense can occur many months after the related revenue is recorded thus it does not matches the revenue and expense within the same period and accurately states the value for accounts receivable.

Allowance method would use the contra-asset account to accounts receivable i.e. allowance for doubtful accounts, for determining an estimation of accounts that may turn to be bad debt. The account would be an adjustment as accounts are written off. For example: XYZ company estimates the company's bad debt to be at 3% of accounts receivable. At the year end, the accounts receivable balance equals $450,000 and the allowance for doubtful accounts is nil. The accounting entry for recording the estimation:

Dr. Bad Debt Expense $13,500

Cr. Allowance for Doubtful Accounts $13,500

Two months later, XYZ Company decides to write off $3,000 of the overdue invoices of the customer. The accounting entry for recording the write-off:

Dr. Allowance for Doubtful Accounts $3,000

Cr. Accounts Receivable $3,000

It makes sense use the allowance method over the direct write-off method because:

-- Income statement will report the expense of bad debts closer to the time of the service or sale.

-- Balance sheet will provide a more accurate net amount of accounts receivable which would be actually turning to cash