Question

please describe the difference between the following three methods: - Direct write off - Percent of Sales - Percent of AR and AR Aging

Answer 1

Under the direct write-off method, the bad debt expense is recorded when a receivable is determined to be bad and uncollectible. The bad debt expense account is debited and accounts receivable credited. There is no estimation involved in the direct write-off method. Also, the direct write-off method is not in accordance with the GAAP since it violates the matching principle as the sales and receivables are recorded in one accounting period but the related expense may be accounted for in a different accounting period.

Under the Percent of Sales method, the bad debts are estimated as a percentage of the sales during the period. The net credit sales are generally used in the computation. The percentage is arrived at based on past statistics and trends. Under this approach, the existing balance in the allowance for bad debts account is not considered while recording the bad debt expense for the period. This method is also known as the Income Statement approach.

The Percent of AR and AR Aging method is also known as the Balance Sheet approach. Under this method of estimating bad debts, the allowance for bad debts is estimated as a percentage of the accounts receivable balance at the end of the period. The estimation is usually done based on an aging analysis of the accounts receivable balance. The likelihood of collectability of receivables outstanding for longer durations is lower than it is for current or more recent receivables. The percentage used for estimation of the allowance for bad debt is hence generally higher for the long outstanding receivables than it is for current receivables.

The bad debt expense is then calculated as a balancing amount after considering the beginning and ending balances in the allowance for bad debts account and the bad debts written-off if any during the period.

The AR Aging method provides a more accurate estimate of the allowance for bad debts and bad debts expense.

Thus, under the Percent of Sales method and the Percent of AR and AR Aging method, the bad debt expense is recorded at the time of estimation of the uncollectible receivables and before the account receivable actually becomes uncollectible. The write-off of the account receivable is done when it is actually determined to be uncollectible by debiting the allowance for bad debts account and crediting accounts receivable. These two methods are thus permitted under GAAP.