Memo to President of the Manufacturing Firm
The primary aim of this memo is to provide answers to your doubts and concerns with respect to the application of the allowance method in preparing records for uncollectible accounts. The memo starts by addressing a little about the allowance method and comparing it to the direct write-off method. It then provides clear illustrations of the rationale behind the recommendation to use the allowance method over the direct write-off method. The discussion in the memo will help you to have a better understanding of the issues you raised upon the recommendations in the company’s financial reporting practices.
Comparing Allowance Method to Direct Write-off Method
For the purpose of enhancing a better understanding on this issue, it is worth reflecting on the main methods upon which your concerns find its basis.
The allowance method of accounting uses provides a provisional percentage of the accounts that are bound to be uncollectible. As soon as a particular account stands out as uncollectible, a debit and a credit are added to the allowance for doubts account and the account receivable accounts respectively.
According to the provisions of the direct write-off method, an uncollectible account expense is only recorded when an account has been determined and certified to be uncollectible. The above means that the reorganization of costs is not always in the same year the corresponding revenues feature in records.
Reasons for Recommending the Allowance Method
While using the allowance method, the accountant makes an estimate of the accounts receivable that may end up uncollectible at the end of the accounting period. The estimate is usually percentage based and utilizes the historical analysis of account receivable records. The estimate passes as an expense and is recorded in the provision for doubtful debts account. The resulting cost falls in the operating expense account, just like any other general, selling or administrative expense.
The accounts opened under the allowance method are written off as soon as the process of taking all the appropriate measure is over. The actions, in this case, involve determining that the collection of debts is impossible due to factors such as the customer being declared bankrupt. Once the above is true, the accountant records the write-off amount in the provision for doubtful debts account thus removing that particular amount in the receivable account. All the above is useful in that it helps in the following ways:
- The estimated uncollectible accounts reflect in records in the same year as their corresponding sales. As a result, the expenses and their related revenues are reported in the same accounting period. The above helps in determining the net income in a particular financial year in the most appropriate way
- On another perspective, the generation of revenue through sales calls for the incurrence of expenses such as those recorded in the uncollectible expense account. The allowance method is in fulfillment of GAAP’s matching and expense recognition principles. In light of the above, using the allowance method helps the company to keep financial records and reports according to the provisions of international financial recording standards.
- The value of the cash realizable in the accounts receivable is reported appropriately under the current asset segment in the balance sheet. The above helps to disclose the expected cash possible for collection from the debtors. The appropriate representation of figures in the statement of financial position is helpful since it is the record used in determining the fairest value of the company at any one time.
With reference to the above reflection of how the allowance method works as well as the advantages of using it for the purpose of financial reporting, I hope that you now understand the reason for its recommendation.
In case you need further clarification on matters relating to the above, please feel free to contact me.