Q8(c): Discuss the differences and implications between the ‘allowance method’ and the ‘direct write-off method’ of accounting for bad debts. (3 marks)

The 'Allowance Method' and the 'Direct Write-off Method' are two different approaches to accounting for bad debts.

1. Allowance Method: This method involves estimating uncollectible accounts at the end of each period. It provides better matching of expenses and revenues on the income statement and ensures that receivables are stated at their cash (net) realizable value on the balance sheet. The allowance method is required for financial reporting purposes when bad debts are material in amount.

2. Direct Write-off Method: This method charges the loss to Bad Debts Expense only when an individual account is judged to be uncollectible. This method is simpler than the allowance method but it fails to match expenses with revenues and it overstates assets on the balance sheet.

Implications:

• The Allowance Method is generally preferred because it adheres to the matching principle of accounting, where expenses are matched with revenues in the period they are incurred. This method provides a more accurate picture of a company's financial health by showing the anticipated loss from uncollectible accounts.

• The Direct Write-off Method, on the other hand, can distort a company's profitability in the period when the bad debt expense is recognized. This method is not in accordance with the generally accepted accounting principles (GAAP) but is acceptable for small businesses that sell to consumers rather than to other businesses.

In conclusion, the choice between the two methods can significantly impact a company's financial reporting. The Allowance Method is generally more accepted for larger businesses, while the Direct Write-off Method may be used by smaller businesses due to its simplicity.