The accounting concept of bad debts provision is important for business professionals as well as those affected by natural disasters. People fail to repay loans in unexpected situations, such as natural disasters and job losses. It is therefore necessary for businesses to take measures to manage this financial risk. As the external environment changes, different parts of accounting become more visible. For example, bad debt provision has its own special methods that differ from those of other types of expense.
There are two basic methods to account for bad debts. The direct write-off method and the allowance method are both methods that use estimates to record bad debts. The direct write-off method reduces the allowance amount by eliminating a credit balance in the account, allowing a company to record a debit for cash collected after a customer has been written-off. The allowance method records the uncollectible amount as an expense in the same period as the income. This allows for more accurate representation of actual sales.
The allowance method accounts for bad debts by allowing companies to write-off the uncollectible portion of the accounts receivable balance, while the direct write-off method matches the actual amount of revenue to the amount of receivables. With the direct write-off method, the bad debts expense is written off only when specific receivables cannot be collected. This method is less theoretically correct than the allowance method, since it does not match all revenue and expenses in a single reporting period.
Direct write-off method
The direct write-off method of accounting for bad debts expenses has its advantages and disadvantages. Unlike the accrual method, this expense does not reduce recorded sales but increases it. For example, if a customer owes you $10,000 but pays only $8,000 after two months, you would write off $2,000 in bad debts expense instead of crediting the accounts receivable account. The negative balance is then written off from the bad debt expense account, while the revenue account is unchanged.
When bad debts are not collected, the company must record a loss in the Bad Debts Expense account. It credits the amount to Accounts Receivable. However, this method does not follow the matching principle, which requires expenses to match revenues. This makes it harder for investors to understand the revenue and expenses. Moreover, the amount that is written off will be reported as a loss on the balance sheet even if it is not actually written off.
Percentage of sales method
The accounts receivable aging method allocates a percentage to receivables based on their age. These percentages are estimates based on a company’s history of collecting debts. These are multiplied by the total receivables during the specified time period and added together to determine the bad debts expense. The percentage of sales method, on the other hand, assigns a dollar amount to bad debts based on a company’s net sales.
In either case, a percentage of sales is applied to the account receivables account. The amount of credit sales that are uncollectible is determined by examining evidence. Companies usually decide that eight percent of credit sales will prove worthless. After calculating the amount of uncollectible accounts, an adjusting entry is made to prepare financial statements. The account balance that is reported as a debit must be raised to $32,000 to be categorized as a bad debt expense.
The units of production method of the unit-of-production depreciation model values assets according to the number of units they produce or use over time. This method works best for assets that are used to manufacture goods, such as production machinery. The unit-of-production method is especially appropriate for industries that are highly dependent on machinery and equipment to produce their outputs. The units of production approach is more appropriate for manufacturing than for other types of depreciation methods, and is often used to value deteriorated machines.
When depreciating rental properties, it’s important to determine if they’re still eligible to be written off. Some property costs can be expensed in the year they’re purchased, while others must be written off in the year the property is sold. If you’re unsure whether an asset is eligible for depreciation, seek professional financial advice and consider filing IRS Form 4562.
In conclusion, it is important for a business to account for bad debts in order to protect its financial stability. By setting aside money to cover the potential losses associated with uncollected debts, a company can avoid future expenses and ensure that its finances are in order. Furthermore, by taking these measures, a business can demonstrate to its creditors that it is a responsible and reliable organization.