 In this discussion, we will discuss the discussion question of compare and contrast the direct write-off method and allowance method. So considering the direct write-off method and the allowance method, we would need to know first. What are we talking about here? What is this related to? What methods are these for? And they both have to deal with accounts receivable, the valuation of accounts receivable. So we have this problem with accounts receivable, and this is how I would approach this if we were to write this out in a discussion and or essay question to list out the problem that these two methods are trying to solve and then explain how they both solve the method and where the pros and cons of either method are. So we have a problem with accounts receivable, and that problem is one you'll really find if you teach accounting at some point. That students often when you or anybody who's learning accounting when you often say that we're on a cruel method and we're going to record accounts receivable and sales at the point in time we make the sale rather than the point in time we get the money, which will be sometime in the future. It's often pointed out that we're kind of recording the asset on the books as well as the sales before we get any money, and what if we never get paid, which is probably probably happens time to time. We're going to do some work from time to time, and we're not going to get paid. And therefore, we're overstating in those circumstances the assets because the assets are going up by the accounts receivable and the revenue. Note what we're not doing. We're not overstating cash because we're not recording cash, but we are recording an asset that's a current asset called accounts receivable, and we're increasing it even though we haven't gotten paid. Therefore, the readers of the financial statements, if we look at this from the readers standpoint of the financial statement, we have to record it still because if I'm reading the financial statements and people owe the company $100,000, that's important to me. I want to know that. I recognize the fact that the $100,000 that people owe the company is not the $100,000 in the bank account, which would be preferable in terms of having a better looking financial statement. But $100,000 is still something I want to know about when making financial decisions. So it has to be on there when we want to make the best financial statements for decision makers. However, to make them better for decision makers, we should also tell the readers of the financial statement that, hey, we have some pretty good idea of how much of those receivables are not going to be collectible, not based on our current clients, particularly, but based on past history and history of related industries, on how good a payment there is for receivables. And on the income statement side, we also want the same issue, which is that if you're recording, you know, $100,000 in revenue, we want to know, well, if those were all made on accounts, meaning we never got the money for it, it's not really a sale if we never get the money for it. So, or at least we should write off the bad debt related to the sale. So we need to be able to record that, make some type of estimate for the balance sheet side and the income statement side. So in other words, we need to tell our reader how much of the accounts receivable we think is uncollectible and how much of the sales that we made this year, this time period that we are reporting, that we don't think are going to ever get paid on. And so there's two methods we can do that. We can do the direct write-off method and the allowance method. Now the direct write-off method is a simplified method. It's not usually a method that we can use under generally accepted accounting principles unless we believe that the amount will be in material that will be written off, meaning it's not too large for decision-making purposes and therefore we can use whatever method we want, typically the direct write-off method being easier and that's going to be the pros of the direct write-off method, meaning there's no estimate or there's less estimates on the direct write-off method. For example, if we make a sale, we're just going to wait until we are pretty sure that we're not going to get paid and then we'll write off the bad debt. So at some point if we made a sale today and we're not going to get paid on it but we don't realize that until five years out, then we'll write it out five years out. We'll write it off, meaning we'll debit bad debt expense reducing that income and we'll credit the accounts receivable five years later after we've tried to collect on it for that time period. The problem with that is that for that five-year time period we had a receivable on the books which is overstated in our assets and we had income recorded on year one of that five years which wasn't really, or net income was too high because we didn't really make a sale because we're not going to get paid on it. So that's the problem with the direct write-off method. It's easier that way because there's not as much estimate. We don't have to make an estimate on how much we think it's going to be uncollectible but it's not as accurate because it doesn't apply to the matching principle in terms of the income statement side and it overstates the assets typically on the balance sheet side. It can also be abused by management. I mean if we wanted to make our revenue look higher or lower, if we wanted our revenue to look higher this year, we might have bad debt expense that we're pretty darn sure that isn't going to, we're not going to get paid on and instead of write it off the management might have more incentive to write it off next year and under the direct write-off method it's more possible basically to do that, to basically determine when you want to write off and if we want it for whatever reason, net income to be lower in a certain time period possibly for taxes, we might decide to write off, you could say okay I've determined now that these bad debt expenses are uncollectible and lower net income by writing them off during that time period and so there's some arbitrariness in terms of when is something going to be non-collectible whereas if we do the allowance method we have to make some type of estimate of how much was going to be uncollectible and you could say that there's also a room for abuse there because it's an estimate and we can make a high estimate or a low estimate and that could change net income however the fact that we need to make an estimate and it needs to be reasonably done within industry standards and not be made individually based on a client-by-client basis or customer-by-customer is actually a bit more assured meaning we can look at it and say is it reasonable if you compare this estimate to other industries that this uncollectible amount would be reasonable, it might could be argued that that would be easier to do but in any case the direct write-off method should be better with the matching principle of uncollectible and the idea there is that the asset side, the accounts receivable, we think we're going to figure out how much we think is going to be uncollectible during this time period in some way. A couple of ways we can do that one way is to look at the aging for accounts receivable and try to determine based on related industries and past history how much of it is uncollectible and then set up an allowance account, allowance for uncollectible accounts which is a contra asset account, it's going to be an asset account with a credit balance so the net of the accounts receivable and the contra account would then be what we actually think is going to be collectible. So now we're telling our reader hey this is how much people owe us, this is how much of it we believe is uncollectible the difference between those two, the subtraction of those two is what we think are true receivable is and that would be the if those can be accurate numbers that would be the best representation for most readers of the financial statements. On the income statement side we're going to say here's our revenue and here's the bad debt expense not the bad debt expense that we think is going to be uncollectible due to we determined that particular clients are not going to be able to collect it meaning bad debt expense is a revenue that happened in prior periods prior years prior months but we're looking to try to make some estimate of the bad debt related to the revenue that we actually earned this time period and match it up in that way that being a better format of the matching principle so we're going to say hey we earned 100,000 we think of that 100,000 that so much of it you know 5,000 isn't going to be collectible based on past history based on an estimate we have made. So it's going to be the major difference between the two remember that the allowance method is going to be generally accepted accounting principles typically the method preferred under generally accepted accounting principles and accrual concepts the matching principle in particular but may be allowed for a direct write-off method if the amount to be written off is typically small in material to decision making or if you're talking about a smaller company which doesn't have as much requirements to use something like an allowance method a smaller company may say hey it's just it's it's more confusing to do an allowance method it takes more time than the added information I'm benefiting from doing what's typically considered to be a better more accurate method the allowance method the direct write-off method might be simpler and therefore for a smaller company easier to use and easier to deal with those are going to be the pros and cons between the two.