Q1. When a company has a policy of making sales for which credit is extended, it is reasonable to expect a portion of those sales to be uncollectible. As a result of this, a company must recognize bad debt expense. There are basically two methods of recognizing bad debt expense: (1) direct write-off method, and (2) allowance method.
(a)Describe carefully both the direct write-off method and the allowance method of recognizing bad debt expense, give a numerical example with the journal entry for each method. (1.5 marks)
(b)Discuss the reasons why one of the above methods is preferable to the other and the reasons why the other method is not usually in accordance with IFRS. (0.5 mark)
The bad debts are the accounts receivable which are uncollectible. In direct write off method, the debts are written off as bad only when it is confident that the debt is irrecoverable which means the expense is recorded only when the bad debts are materialised.
In allowance method, the bad debt expenses are estimated as percentage of accounts receivable at the end of the year. The actual bad debts are written off against the allowance for doubtful debts when the bad debts are actually materialised.
During the year one of debtor run away and Abdullah companycannot realise it’s balance of $5000 then the journal entry for this will be
Bad debts expense 5000
To Accounts receivables. 5000
The direct write off method is easiest method to write off the bad debts. However, it has drawback. It violets the matching concept.The revenue from sales is recorded in one year and if the bad debts expenses are materialised in the next year, then expenses are charged in the next year. This is not correct as per the matching concept we need to recognise the expenses related to revenue in the same year in which year revenue is recognised.
In allowance method, the bad debts expenses are estimated based on percentage of accounts receivable balance at the end of the year and allowance for doubtful debt is created accordingly which means expenses are recognised in the year in which sales revenue is recognised.
Therefore, the allownace method is usually preferred for recognizing bad debt expenses.
X company Estimates 1% of 500,000 sales revenue will not be collected, the journal entry will be
Bad debts expense 5000
To Allowance for bad debts 5000
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