Some companies even get the assistance of debt collection agencies to collect due amounts from customers. While some level of bad debts is inevitable, businesses should always attempt to maintain it at a minimum level since accounts receivable is usually considered as a very important current asset as far as liquidity is concerned. Depending on past experience, it is estimated that 8% ($4,000) will be bad debts. XYZ Company has $50,000 outstanding from customers at the end of the financial year. The percentage that should be estimated as bad debts will be decided on past experience of nonpayment by customers.Į.g. Since the actual amount of bad debts that will materialize from this allowance is unknown, it is also referred to as ‘ allowance for doubtful debts’. Therefore, this method is compatible with matching principle. Under this method, an allowance for possible bad debts is created for the same accounting period in which the credit sales are made. This is evident from the above example where the credit sale takes place in 2016, and the bad debt is discovered in 2017. This violates the matching principle (expenses should be recorded for the period where the revenue is incurred) of accounting because it recognizes bad debt expense which may be related to the previous accounting period. This a simple and the most convenient method of recording bad debts however, it has a major drawback. ABD should record the bad debt as follows. By the last week of February 2017, Customer G was declared bankrupt and was unable to pay. On, ABD Company sold goods worth of $1,500 to Customer G with a credit period of 3 months. The account is removed from the accounts receivable balance and bad debt expense is increased.Į.g. The direct write off method allows a business to record bad debt expense only when the company is confident that the debt is unrecoverable. Side by Side Comparison – Direct Write Off Method vs Allowance Methodĥ. When goods are sold on credit, the customers settle due amounts at a later date.Ĥ. The key difference between direct write off method and allowance method is that while direct write off method records the accounting entry when bad debts materialize, allowance method sets aside an allowance for possible bad debts, which is a portion of credit sales made during the year. Direct write off method and allowance method are the two widely used methods to account for bad debts. This is considered an expense because bad debt is a cost to the business. When an account is deemed to be uncollectible, the company must remove the receivable from the accounts and record an expense. If a customer defaults the payment, this will be called a ‘ bad debt’. Direct Write Off Method vs Allowance Method
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