In this presentation, we will take a look at a comparison between the allowance method and the direct write off method. When considering both the allowance method and the direct write off method, we are considering the accounts receivable account. Remember that the accounts receivable account represents some money that is owed to the company, typically from sales made in the past, on account haven’t yet received the funds for sales made in the past and therefore, the company is owed money. We see this amount on the trial balance in this case 1,000,001 91. We then want to know information about that, including who owes us that money. We can’t find that typically in the GL as we have a GL for every account the GL only giving us the information by date. Typically, we want to see that information also broken out in the subsidiary ledger saying who owes us this money.
A problem that we have is that the accounts receivable represents funds we have not yet received and may not receive. If there is some problem with some customers, we might not get the funds. The question then is, should we be writing off this amount at the point in time that we believe we’re not going to be able to receive it? Should we be estimating how much we think is not going to be collectible or waiting until the end of the time period until we determine that something will be uncollectible, the generally accepted accounting principle the principle that we should typically be using, if under gapped and Accepted Accounting Principles would be an allowance method, meaning that we would be writing off or matching up with the accounts receivable and allowance account. That would be an estimate showing us what we think or believe based on past experience will be uncollectible on the balance sheet, and that would write down the accounts receivable and not overstate the accounts receivable.
And we would also be writing off the bad debt expense then at the point in time, too. matched it up with the revenue at the same point in time. The other method is going to be the direct write off method, which typically is not a generally accepted accounting principles method unless the amount of the uncollectible receivables is substantially small and therefore not material to decision making. Otherwise, if we’re if we’re a smaller company, and we’re not publicly traded, we may not have to be regulated under the same type of rules and may not be restricted to the method we use. And therefore we need to make a decision do we want to use one method or the other, the direct write off method has the benefit of typically been easier to use, because we can just wait there’s no estimate happening. We can wait until we believe something is not going to be collectible, and then write it off. Note that that does distort the income statement in some ways, because we’re writing it off at a later time period and therefore not matching it up with the revenue earned in that time period. It also gives us an ability to distort net income in some ways, because we can make a decision at the end of the time period to write it off or not, maybe we wait until the next year or not.
Whereas if we use an allowance method, an estimating method, then we have to make some type of reasonable estimate. So those are going to be the pros and cons between the book The two methods we’ll go through and look at them both. So here’s going to be the direct write off method, where we are going to say that this customer’s not going to pay us 9000. We’ve determined it at this point in time, and therefore we’re going to debit bad debt expense and credit the receivable at this point in time. The difference here being the bad debt expense, which brings down net income at the time when we determined it’s uncollectible. If we post this to the general ledger, we’re going to say that bad debt is going to go up from zero up to 9000 by this debit, that 9000 then represented here on the trial balance. The accounts are receivables gonna go down because they don’t owe us any more money or we’ve given up on it. The receivables can be credited. Here’s the GL Account 1,200,000 going down by the 9000 to 1,000,001 91 that then being represented on the trial balance as well.
We can see then on the trial balance that we have the the revenue is now going down by the bad debt, the net income then being decreased at the point in time we determine that the bad debt would be uncollectible. We also want to see the the information that would back up the accounts receivable that would be on the accounts receivable subsidiary ledger. Here’s the CW company only has 9000. We’re writing that off, bringing the balance down, down to zero after that point in time after we write this off, so now it’s down to zero. That would be owed to a certain remember that the subsidiary ledger would include all people that owe us money, all companies and people that owe us Money.
And if we added them up, it would tie out to what is on the trial balance as well as was on the general ledger. If we contrast that to the allowance method, we have the similar journal entry, decreasing the receivable here, but the other side not go into bad debt, but instead go into the allowance account. So now we have the same accounts receivable result, it’s starting at 1,000,200, going down by 9000 to 1,000,001 91. However, now we’re using this allowance account, which we weren’t using before, we just had it as a demonstration. And we had already estimated that there’s 40,000, that was made in the prior period, the prior year, or the prior month that we wrote off in the prior period to match it up to the revenue in that period. And we created this allowance account. And now we’re just going to write down that allowance account. No effect down here to bad debt at this point in time, no effect and net income at this point in time. We at the end of the period will make an estimate based on the revenue and or the accounts receivable. To determine how much of this revenue we think is going to be uncollectible and therefore be matching up with the matching principle.
So in this case, when we write it off, there’s no effect on the net income accounts. It’s just affecting this allowance account, which we had set up prior. And we still have the decrease from the 9000, down by the 9000 to zero in the accounts receivable, same activity in the trial balance, I mean, the general ledger terms of accounts receivable, back to that 1,000,001 91 1,000,001 91. If we take a look at a side by side comparison, here’s the bad debt, the direct write off, and here’s the allowance method. So here we’re not using the allowance account and of the direct write off method. It’s just there to show what account would be used under the allowance method. It’s not being here used under this side. Direct write off it is being used over here, we can see that we have the 1,000,001 91 method in the allowance. It’s not it’s not a relevant account under the direct write off method. Over here, we still have the 1,000,001 91. But we have this 31,000, which was there prior was created prior to this time period when we wrote off the bad debt related to the prior time period, so this 31 is still leftover that we think could be uncollectible or become uncollectible at some point in the future based on an estimate. on the income statement side, we decreased net income by that 9000.
So the 370 8000 minus this 9000 is the 369. On the allowance method. No write off the bad debt at this point in time. We won’t write it off until we make an estimate at the end of the time period based on either revenue or our accounts receivable. Next transaction g company payment 20,000 of 30. This is going To be the direct write off half of this. So we’re looking at the direct write off, we’re going to say that we did get cash, so we debit the cash it’s increasing, then the accounts receivable is going off the books for the 30,000, the entire amount owed, we’re not going to get the added 10,000. The difference then it’s going to be the 10,000. We have to put it somewhere this will be the difference between the two methods. under the direct write off method, we’ll write it off to the bad debt expense under the allowance method as we will see in the next slide, it would be going to the allowance for doubtful accounts. If we record this then cash is going to go up to 100,000 plus to 20,000 to 120. We can see the accounts receivable is going to go down we were at 1,000,001 91, down by the 30,000 to 1,000,001 61. This matching up with what’s on the trial balance down the 1,000,001 61 and 120,000.
And then we have the bad debt, which is going to go from the 9000 up by 10,000 to 19 thousand. That, of course over here on the trial balance as well. Note that we are increasing bad debt expense at this point in time, that being the difference that then affected net income, net income going down. We also want to remember that we will be recording something to the subsidiary ledger, this company, this particular company owes us 30,000, we’re going to decrease it down by 30 to zero, meaning they’re not going to owe us anything anymore, even though they only paid us 20. We’re not going to leave the 10 there that they still owe us we gave up on it, and therefore are going to write the entire thing out down to zero. Contrasting that with the allowance method, we still got the cash we still got the receivables going down to zero, but instead of the 10,000 go into bad debt now it goes to the allowance for doubtful accounts.
So we have the same effect on the accounts receivable 1,000,001 91 down by that 30,000 to 1,000,001 61. Same effect on the allowance For, I’m sorry, same effect on the subsidiary ledger, the company going down to zero in terms of the subsidiary ledger 30,000 minus the 30,000. to zero, the difference being that there’s no impact on the income statement, bad debt not being affected, no effect on net income. What is happening is we have this allowance account, which was at 31, prior to this, now going down by that 30,000 to the 21. Remember that this 31 was there prior to this time period. It was there created from the prior time period based on an estimate. And we created the bad debt expense based on either the revenue or the accounts receivable. And then we closed it out.
Of course, that’s why there’s nothing in bad debt expense because it got closed out the end of the year or the end of the month, and therefore is at zero and we’re writing off the uncollectible receivables here that has already hit the income statement. In our estimate, we estimated it prior to this, wrote it off in the prior time period, it been rolled into the capital account in the closing process and therefore is not on the income statement for this time period. And we’re just writing off the bad debt to the allowance account, we will have a bad debt won’t happen, however, until we make an estimate at the end of the time period. If we compare and contrast the two, then this is the bad debt. This is the allowance method. This is this is the direct write off method. This is the allowance method. We have no allowance for doubtful accounts is just there for demonstration we’re not using it under the direct write off method, we have 19,000 of people that we have determined will not be collectible, and therefore wrote them off decreasing net income by that 19 that 378 minus the 19.
Bringing net income to net income of 350 9000. We have the same receivable over here, but then we have the assets allowance account, it’s now going down to 21,000. Because that’s where we wrote off to people that we have determined that would be uncollectible, no effect on bad debt expense, no effect on the income statement from writing off these accounts thus far. Next one, we’re going to say receive payment from CW after writing it off. So this is that unusual one, it doesn’t happen all that often in real life, we’re going to first take a look at the direct write off method. This is a really good example problem, though, because it allows us to see the difference between the two methods. And what would happen if we if we had to reverse our write off. And so it makes us think, kind of backwards, which is great for testing and our knowledge on this type of stuff.
So we wrote CW off we said, Hey, they’re not going to pay us the 9000. And then they came in even without our collection actions, we gave up collecting the money, and they came in and paid us and that’s great. So you would think that we would debit cash and credit somebody Other accounts, we couldn’t credit accounts receivable because we already wrote it off. We wrote it off, in this case under the direct write off method to bad debt. So you would think we can just debit cash and credit bad debt. But if we did, so, we wouldn’t have it run through the receivable account. And if we looked at the at the receivable subsidiary ledger, it looks like this 9000 is due to them not paying us and we want to show that they did pay us and therefore under either method, we do need to reverse what we did prior to give us a paper trail that this client is good. So therefore, we’re going to reverse what we did last time under the direct write off method. We credited accounts receivable and we debit bad debt. We’re going to reverse that. We’re going to put them back on the books increasing the accounts receivable by the 9000. Decreasing bad debt unusual account here bad debt and expense typically only going up with debits. This is an exception to the rule.
We are reversing it under the direct write off method. This The difference between the allowance and direct write off under the allowance method, this would be the allowance for doubtful accounts account. Once we do that, then we can just do our normal transaction that would happen if a company came in and paid us on account debiting the checking account, increasing the checking account, crediting accounts receivable, decrease in accounts receivable note between these two journal entries, here’s accounts receivable, here’s accounts receivable, debit credit, doing the same thing. If we eliminate those two, we’re left with a debit to the checking account, credit to bad debt. So we could shorten this from just a technical standpoint to just this with one journal entry. But that doesn’t give us a good paper trail. Therefore we don’t do that. So we both this then we’re going to say accounts payable is going to go back up by the 9000 to this and then we’re going to say that the bad debt is gonna go down. Here’s the 9000 here.
We’re now eliminating it. That brings us to the 10,000 down from 19. And then we have the cash account, which is going to go from 120 up by the 9000 to 120 9000. And then we’re going to have the second component, which is going to be this item here, the accounts receivable going down bringing the 1,000,001 70 down by 9000 to 1,000,001 61. That’s where we’re at now on the accounts receivable and the trial balance and then we got the subsidiary account, and that’s went from zero, it’s gonna go up by 9000 to 9000. And then we’re taking it back down again, down by 9000 to zero. So the accounts receivable subsidiary account went from 9000 credit back to zero, then we debited it by this 9000 here, bringing it back up to 9000. Then we credited by 9000, this looks really repetitive, because it just this is where we started. And then it went up and then it went back down. But this gives us a paper trail this item, if we were to drill down on it, which show that we got paid here, whereas this item, if we drill down on it would show that we gave up on the customer.
So that’s the important difference between reversing this rather than just recording a debit cash credit to bad debt expense. If we look at the allowance method, same type of activity, we’re going to reverse what we did, and then we’re going to record the normal transaction. The only difference here being this item when we first recorded the write off, we debited the risk. we debited the allowance for doubtful accounts and credited the receivable. Now we’re just reversing that. So we debit accounts receivable just as we did under the direct write off, but instead of crediting the bad debt now crediting the allowance Just reversing it, then we’re back in good standing. And we can do the same thing that we did in the direct write off method, or the same thing we would always do when we receive cash on account debit and cash, and increasing cash and decreasing with credit accounts receivable. So note here, no effect on the net income, the allowance account, then it’s going to go back up from 21, up by the nine to the 30,000.
And that’s because of course this individual did pay us so we’re not taking it taking that down. The accounts receivable account on the general ledger went back up and then went back down so we can see it just went up, down. Same thing, we put it back in and took it back out. If we look at the CW account here, this is where we started. Same thing his subsidiary ledger account for this customer goes back up by nine and back down. Everything is the same except for this allowance account being the river In account we’re using non affecting the bad debt expense. And the way to think of this is just to think about what did we do before and reverse it. We look at the comparison, here’s the direct write off. Here’s the allowance method, direct write off, I’m showing the allowance account here, but it’s not used. It’s not being used here. So that’s why it’s red. It’s not gonna, it’s just a placeholder.
And what we did was change the bad debt expense to write off or reverse what happened and then record our normal increase in the checking account and receivables. Under the allowance method, we have the same thing except no effect on bad debt. The adjustment that happened happened here in the allowance method, increasing that allowance back up we will have the bad debt at the end of the time period. When we make an adjustment under the allowance method. These will be the major differences when recording the normal transactions are for a an individual or customer that is determined to be uncollectible and when they pay as an After we wrote them off, going forward, the allowance method will then have an adjustment in order to record the allowance for doubtful accounts based on either the revenue method here in terms of how much revenue was earned, taking a percentage of that to determine what the bad debt would be matched up against that revenue, or use a balance sheet method and taking a look at the accounts receivable and determining how much of the receivable is going to be uncollectible Either way, it’s better in terms of a matching method.
So the next step on the allowance method would be to determine in some way, what the bad debt expense is not in the case not buying knowing or finding out who is not going to pay us this time period from sales made in the past, but instead making some type of estimate in terms of of this revenue made this time period, how much of it will not be paid, thereby matching up the expense to the related income in the same time Period. That estimate once again could be made either by looking at revenue, taking some kind of percentage or some type of estimate based on the revenue earned at this time period this month this year, or look at at the balance sheet account and seeing how much of this we believe is going to be uncollectible that then get into the same number of bad debt, but doing it in kind of a reverse type of way. Whatever we discern, the type decide is uncollectible, whatever we have to adjust this allowance account to be, the difference will be the bad debt expense here that will be matching up revenue and expenses.