The rationale for using the allowance method
The allowance method determines the percentage of credit sales that cannot be cashed within the credit period set by the company. The contribution used to estimate bad debts is based on previous experience with the businesss creditors. A company may decide to set an allowance of 2% of the credit sales as the projected bad debts. In a case where a company has made credit purchases worth $20,000, the company could create an allowance of 2 % ($400). This allowance is a contract asset item that appears on the businesss balance sheet.
The reason this method is used is to match the bad debts expense to the credit sales made (Matching principle). The resulting allowance is created when the credit sales are made. The company does not wait for creditors to default payments. Rather, it produces the benefit to ensure that expected profits are projected realistically. The method of establishing an advantage relies on past experiences of payments made by creditors. The allowance can be varied depending on the credit sales made during the current period. In a period where the credit sales are higher, the allowance will be increased together with the risk of defaulted payments.
A contrast of the allowance method based on credit sales to estimate bad debts with the allowance technique based on the balance in the trade receivables accounts
The allowance method based on credit sales estimates bad debts by credit sales made during the current period. In this method, Carme Company sets the provision for bad debts as a percentage of the credit sales made and not by bad debts determined from the uncollectible amounts in the accounts receivable. In a period where the credit sales are higher, the estimates of bad debts will be higher than periods when credit sales are lower. The allowance method based on the balance in the trade receivables, accounts determines the allowance for bad debts Carmes Company is to set based on the payments defaulted in the previous periods. Debts that have been outstanding for a longer time are accorded a higher allowance than more new debts. It is easier for creditors to default on payments that have been outstanding for a longer period.
How Carme Company should report the payment for bad debts, account on its balance sheet at December 31, 2014
Allowance for bad debts is a contra-asset entry. In the balance sheet, this allowance is deducted from the accounts receivable to get the net available accounts receivable. In our example, taking credit sales of $ 20,000 and bad debts allowance of $ 400.The net realizable accounts receivable will be calculated as illustrated: Accounts receivable ($20,000) less bad debts allowance ($400) which results in $19,600 (net realizable accounts receivable).
An increase in the provision for bad debts will reduce the net available accounts receivable while a decrease in the payment of bad debts will increase the net available accounts receivable.
Alternatives, if any, for presentation of bad debt expense in Carmes 2014 income statement
Bad debt expense can be presented in the statement of operations as a revenue expense. Revenue expenses are directly related to changes in the companys revenue. It is categorized as items such as discount allowed, allowances given to creditors and sales returns. In this presentation, the rationale is that bad debts directly affect the revenue of the company. Bad debt expense can also be presented as an operating expense (non-cash costs). These are expenses that are essential for day to day operations of the company, but these activities do not directly contribute to the revenue of Carmes Company. These expenses include overheads such as electricity, wages and postage costs amongst others. Under this presentation, the argument is that bad debts have no direct impact on the revenue of the company until they are deemed uncollectible.
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