What Are Two Methods Used to Adjust Accounts Receivable?
Accrual basis accounting permits sales on credit to be recorded on the accounting ledger so long as the right conditions are met. First, the source transactions that produced the revenues must be complete. Second, the numerical value of sums exchanged or to be exchanged in the transaction must be calculable. Third, there must be no reason to doubt that the sums in question can be collected by the business. Sometimes, such estimates turn out to be wrong and sums thought to be collectible turn out to be bad debt.
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Accounts Receivable and Bad Debt Expense
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Revenues produced through sales made on credit are recorded as accounts receivable. Accounts receivable are listed as short-term assets on the balance sheet and a portion of their value is deducted as bad debt expense once specific accounts are deemed to be uncollectible. Although businesses sometimes choose to maintain separate accounts for separate debtors, all sums owed to them are summed up in one single account for ease of use on financial statements.
Direct Write-Off Method
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Direct write-off method is the simpler method used to account for bad debt expense. It records bad debt expense whenever specific accounts receivable are determined to be uncollectible by the business. For example, if a business determined that a $1,200 account receivable is uncollectible, it records $1,200 in bad debt expense and deducts a corresponding sum from its accounts receivable in that time period.
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Allowance Method
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Allowance method estimates the portion of the business’s accounts receivable that is uncollectible in each time period and then records bad debt expense in order to bring allowance for bad debt in line with estimates. Once specific accounts receivable become uncollectible, their value is deducted from allowance for bad debt rather than recorded as more bad debt expense. For example, if a business estimates that 20 percent of its $40,000 in accounts receivable are uncollectible and it has allowance for bad debt of $7,000, it needs to record $1,000 in bad debt expense. Once an account receivable of $500 is determined to be uncollectible, that is recorded as a $500 deduction from allowance for bad debt and a corresponding deduction from accounts receivable.
Allowance and Direct Write-Off Methods
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The direct write-off method is simpler than the allowance method and easier to use when accounting for bad debt expense. But the allowance method is more proactive and produces more useful financial statements. This is because the allowance method estimates the uncollectible accounts in each time period and records bad debt expense based on those estimates rather than react later as specific accounts are determined to be uncollectible.
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References
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