Q4: Describe the allowance method.
Under the allowance method, we estimate our bad debts in advance; before we know the particular customers (who owe us money) that are not going to pay us. We do this at the end of each period, as we seek to include this expense in the same period as the revenue that resulted in the bad debts expense occurring. Once we have made an estimate of the bad debts expense for the period we include it as an expense in our accounts (DR: increase in expense) and also in a contra-asset account Allowance for doubtful debts (or similar name) (CR: increase in a contra-asset account, similar to reducing an asset). This contra-asset account contains our estimate of the amount of our Accounts receivable which we have estimated will not prove to be able to be collected from our customers who have purchased goods or services from us on credit. The reason we do not reduce directly our Accounts receivable account is because we do not know at this stage exactly which customers will not pay us what they owe us. If we were to credit the Accounts receivable general ledger control account in the general ledger we would also need to credit individual Accounts receivable accounts in the subsidiary ledger; and we cannot do this, as we do not know at this stage which individual customers are not going to pay us.
It is a bit like we are in a dark room with our Accounts receivable general ledger control account and Accounts receivable subsidiary ledgers for our individual customers and we are saying we know we have some customers who will not pay us, we just do not know who you are yet. So, until we find out exactly which individual customers are not going to pay us what they owe us, we cannot adjust the Accounts receivable general ledger control account because we do not know the individual customer’s Accounts receivable subsidiary ledger to reduce at the same time: “We think you are there, but we do not know who you are yet.” And we will remember from Chapter 2 Section 2.1 that the general ledger control account equals the total of each of the subsidiary ledger accounts.
So what we do is have a contra-asset account called Allowance for doubtful debts (or something similar). This is a general ledger account. This keeps the deduction for our estimate of bad debts separate to the Accounts receivable general ledger control account. This keeps the Accounts receivable general ledger control account in line with the total of the Accounts receivable subsidiary ledger accounts for each customer; and also allows us to see clearly our estimated amount for bad debts in a separate Allowance for doubtful debts account.
The allowance method of accounting for bad debts has the benefit of recording a bad debt expense in the same period as the revenue to which it relates (ie the sales made during the year which we estimate will not be paid). It also means we create an account that can be deducted from Accounts receivable in our firm’s balance sheet, which permits us to present our firm’s Accounts receivable based on the amount we expect to recover from our customers.