Explanation :There are two methods available to recognize bad debts expenses . Using the direct write-off method, accounts are written off as they are directly identified as being uncollectible. This method is used in the United States for income tax purposes. However, while the direct write-off method records the precise figure for accounts that have been determined to be uncollectible, it fails to adhere to the matching principle used in accrual accounting and generally accepted accounting principles (GAAP).
Example:The customer takes the inventory, charges the store credit card, and doesn’t actually pay for goods when he leaves the store. The company assumes that the customer will repay the balance on his store credit card, so the company makes an account receivable for the customer. After trying to collect the balance from the customer, the company realizes that they will never be repaid this money.
In a nutshell:
- Bad debt refers to loans or outstanding balances owed that are no longer deemed recoverable and must be written off.
- This expense is a cost of doing business with customers on credit, as there is always some default risk inherent with extending credit.
- To comply with the matching principle, bad debt expense must be estimated using the allowance method in the same period in which the sale occurs.
- There are two main ways to estimate an allowance for bad debts: the percentage sales method and the accounts receivable aging method.
- Bad debts can be written off on both business and individual tax returns.