Q3: What are bad debts expense recognised in a firm’s accounts under the ‘allowance’ method and the ‘direct write-off’ method? Some people say the ‘allowance’ method is ‘better’ in terms of its timing of when to recognise a firm’s bad debts expense? Why, or why not, do you think this might be the case?
Under the ‘allowance’ method we estimate out bad debts in advance (ie before we identify individual customers who are likely not to pay us what they owe us) and recognise (ie include) our estimate of bad debts in our firm’s accounts at the end of each period.
Under the ‘direct write-off’ method we do not do this. We wait until we decide a particular customer’s account is uncollectable before we recognise a bad debt expense.
The ‘allowance’ method has the benefit of recognising (ie including) bad debts expense in the same period as the revenue which resulted in the bad debts expense, thus matching the revenue and expenses in the same period. This can help us better calculate a firm’s profit in a period, particularly where we can make good estimates of our firm’s bad debts (for example, because we have previous experience of selling those good or services and the bad debts that resulted).
The ‘direct write-off’ method recognises bad debts expense when we decide a particular customer’s account is uncollectable. This is usually done when an invoice is overdue for a long period and collection efforts by the business have failed to result in the customer paying the debt it owes to the business. (Study Guide Chapter 5 Section 5.2, page 5-9).
This may or may not be in the same period as when the revenue from the sale to a particular customer was made. To the extent that the ‘direct write-off’ method recognises bad debts expense in a different period to when the revenue from that customer was recognised in our firm’s accounts, then the revenue and expense will not be matched in the same period and our calculation of our firm’s profit for a period will be less accurate or useful.
So, is the ‘allowance’ method ‘better’ in terms of its timing of when to recognise a firm’s bad debts expense? Well, like many things, ‘it all depends’. If we are able to make good quality estimates of our firm’s bad debts (based on our firm’s previous experience of bad debts and using some approaches such as net credit sales or ageing of accounts receivable to help us with making the estimates) then it is better to make these estimates and recognise bad debts expense in the same period as when the revenue was recognised. This helps us better estimate profit for a period, which is something many people are interested in.
If we cannot make resonable estimates of bad debts expense for particular goods or services our firm is selling, then it may not be that useful or practical to use the ‘allowance’ method. In this case, the ‘direct write-off’ method may be fine to use.
However, the accounting standards do require firms to prepare their accounts using accrual accounting:
“Accrual accounting depicts the effects of transactions and other
events and circumstances on a reporting entity’s economic
resources and claims in the periods in which those effects occur,
even if the resulting cash receipts and payments occur in a
different period. This is important because information about a
reporting entity’s economic resources and claims and changes in
its economic resources and claims during a period provides a
better basis for assessing the entity’s past and future
performance than information solely about cash receipts and
payments during that period.” (AASB CF Framework OB17)
To meet this requirement, most firms to whom the accounting standards apply will tend to use the ‘allowance’ method.