When a large account receivable balance is due from one client it is logical to use the direct write-off method to adjust the bad debt expense and accounts receivable balance. Under different circumstances, another method is used called the allowance method. Discuss the best reason(s) for using the allowance method and give some examples of companies that are likely to use that method. Also explain why it would ever be appropriate to use the direct write-off method, especially since it is not GAAP.
Question
When a large account receivable balance is due from one client it is logical to use the direct write-off method to adjust the bad debt expense and accounts receivable balance. Under different circumstances, another method is used called the allowance method. Discuss the best reason(s) for using the allowance method and give some examples of companies that are likely to use that method. Also explain why it would ever be appropriate to use the direct write-off method, especially since it is not GAAP.
Solution
The Allowance Method is often used by companies because it adheres to the matching principle of accounting, which states that expenses should be matched with revenues in the period they are incurred. This method allows companies to estimate and record bad debt expense in the same period in which the related sales are recorded, providing a more accurate picture of a company's financial health.
Companies with a large number of customers, such as retail businesses or utility companies, are likely to use the allowance method. These companies typically have a predictable amount of accounts that will be uncollectible, making it easier to estimate bad debt expense.
On the other hand, the Direct Write-Off Method is not in accordance with GAAP because it does not adhere to the matching principle. However, it is simpler and less time-consuming than the allowance method, making it appropriate for small businesses with few accounts receivable or businesses that rarely experience uncollectible accounts. For example, a small consulting firm with a handful of reliable clients might use the direct write-off method.
In conclusion, the choice between the allowance method and the direct write-off method depends on the size and nature of a company's accounts receivable, as well as the predictability of its bad debts.
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