Question

When a firm offers credit to customers through accounts receivable, they always run the risk that they may not receive the amount owed.

1. The payments not received are called bad debts. This week you learned about multiple ways to remove the bad debts from the accounts receivable account. Why do you think these various methods evolved? In other words, why aren’t all firms using Direct Write-off? If they use the Allowance method, why don’t all firms use Aging of Accounts?

2. Accounting for bad debts is obviously related to the management of accounts receivable. What approaches are available to firms to help reduce the risk of bad debts?

Answer 1

There are mainly two methods to remove the bad debts from the accounts receivable account, namely:

a) Direct-Write Off Method

b) Allowance Method

Earlier, bad debts were directly written off to remove bad debt from the Debtor's Account. But there were many shortcomings of the direct write-off method due to which the allowance method came into existence. The drawbacks of direct write-off method are:

a) Breach of Matching Principle: Generally Accepted Accounting Principles (GAAP) has defined certain rules under the matching principle. According to this principle, all the revenues must be recorded with the matching expenses (incurred to earn the revenue) in the period in which the revenue was generated. But in direct write-off method, the revenue is generated first in terms of credit sales and the expense of bad debt is recognized later. This violates the Matching Principle.

b) Accounts Receivable Overstated: The Accounts Receivable Account shows the amount of money due from customers. It is an asset for the company and till the time bad debt is not recognized, the asset base of the company remains inflated.

c) Error in Profit: The bad debt is an expense for the company and is recorded in the Profit & Loss Account only when they are recognized. So till the time bad debt doesn't incur, the profit is overstated as expenses are not recorded for the period.

So, due to these shortcomings of the direct write-off method, the allowance method came into existence which states the company to create a reserve for potential amount of bad debt when the credit sales takes place.

If the companies use Allowance Method, then all of them do not use the Aging of Accounts Receivable. This is so because aging of accounts maintains the bad debts periodically based on the time duration for which the account has due payment to the company. The period under this method can range from 1-30 days, 30-90 days, so on and so forth. But the reserve for bad debt cannot be created on monthly basis or so. Therefore, all the companies using allowance method do not use aging of accounts receivables.

The approaches available to firms to reduce the risk of bad debts are:

a) By having a stringent credit collection policy. This will allow the debtors to pay on timely basis.

b) To have average collection period as low as possible.

c) To give rewards in the form of offers and discounts to the debtors who pay within a stipulated period. For Example: a 10% off on payments in the payments are made in 10 days. This will be a win-win situation for both the debtors as well as the company. The firm will receive payment within a short span of time (keeping in mind the time value of money) and the debtor will get a relief to pay less and his burden will reduce.

These are the various ways by which a firm can reduce the risk of bad debts.