1. With regards to accounts receivables, it might happen that some of these outstanding debts from customers may not be recoverable owing to a host of reasons. In such a scenario, allowance for doubtful debts is made based on the likely chances of recovery of the given account receivables. Since these are mere estimates of bad debts in the future, hence it reasonable to expect that there may be undershooting or overshooting of this amount in the next year owing to which adjustment entries may be required. These adjustment entries may be credit or debit depending upon the comparison of the actual debts written off with the allowances made in the previous year (Deegan, 2014).
Debit balance in context of allowance for doubtful debts would arise when the actual debts written off in the current year before any end of period adjustment tends to exceed the allowance for bad debts that had been made in the previous year. This implies that debit balance is seen if there has been a under-estimation of the debt that could be written off in the previous year owing to which allowances made were not sufficient to cover the actual debts written off (Arnold, 2015). The debit balance in the current year would reflect this. Simultaneously, it can also be implied that in case an overestimation of debt to be written off is made in the previous year, then a credit balance would arise for allowance for doubtful debts. As a result, it is essential that the allowances should be made as accurate as possible in order to avoid significant debit or credit in the future years (Damodaran, 2015).
An example of debit of allowances for doubtful debts could be taken. Assume that at the end of FY2016, it was estimated that the bad debts written off in the next year would be $ 1 million, then provisions for the same in the form of allowance for doubtful debts would be provided to the same amount at the end of FY2016. However, during FY2017, the actual debts written off were $ 1.5 million and hence exceed the allowances made at the end of FY2016. Thereby, such as scenario would lead to a debt balance with regards to allowances for doubtful debts.
2. With regards to the direct write off method and the allowance method of recording bad debts, it is imperative to note that timing forms the key difference. This is because, the recognition of expense in case of allowance method is done prior or earlier when compared to the direct write off method. The underlying definition of the two would allow better understanding of this timing difference prevalent between the two methods. In relation to making allowance bad debts, it ought to be performed when a reasonable estimate of likely debts that would be written off in the future is available and thereby allowance is made for the same in advance. On the other hand, in case of direct method, the recognition of expense takes place when the outstanding debt has already turned bad and hence completely written off from the account (Deegan, 2014).
Another issue with regards to the usage of the two methods is the matching with the expenses. In case of allowance for bad debts, the provisions for potential future bad debts are made in the very same period when the recording of revenue from sale of goods or services takes place. This leads to superior matching of the expenses with the realisation of revenues. In contract, it is known that the direct write-off method allows recognition only when the debt has actually turned bad and hence write-off from books is actually done. This typically does not fall in the same year as the one in which sale is recorded (Petty et. al., 2015). As a result, if these written off debts are significant, then they may dent the profits of the next year and lead to the issue of mismatching of expenses and income. As a result, it is recommended that in case of organisations where bad debts are significant and also a reasonable estimate of the same can be made, the allowance for bad debts should be recognised so that a more accurate picture of the financial performance of the firm may be presented to shareholders and other key stakeholders (Arnold, 2015).
Arnold, G. (2015) Corporate Financial Management. 3rd ed. Sydney: Financial Times Management.
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
Deegan, C. (2014). Financial Accounting Theory, 4th edn. Sydney: McGraw-Hill
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2015) Financial Management, Principles and Applications. 6th edn. NSW: Pearson Education, French Forest Australia.