Bad Debts Direct Write-off Method Shareholders' Equity
Bad Debts Direct Write-off Method Direct write-off method is one of the two most common accounting techniques of bad debts treatment. In the direct write-off method, uncollectible accounts receivable are directly written off against income at the time when they are actually determined as bad debts. When debt is determined as uncollectible, a journal entry is passed in which bad debts expense account is debited and accounts receivable account is credited as shown below. Bad Debts Expense
——
Accounts Receivable
——
Direct write-off method does not use any allowance or reserve account. Although the direct write-off method is simple, it has a major drawback. Often it violates the matching principle of accounting because it recognizes bad debt expense which is partly related to previous accounting period. For example if sales are made at the end of accounting year 20X1, bad debts will be realized in the beginning months of accounting year 20X2. Thus the use of direct write-off method would cause deduction of expenses of previous period against revenue of current period which is contrary to the matching principle of accounting. Since this method is not according to GAAP, it not advised to use direct write-off method. Instead, use the allowance method for bad debts.
Shareholders' Equity Shareholders' equity represents the interest of a company's shareholders in the net assets of the company. According to the accounting equation:
Shareholders' equity = Assets − Liabilities On a balance sheet, there is separate section for shareholders' equity which includes its components such as common stock, preferred stock, additional paid-up capital, accumulated other comprehensive income, treasury stock and retained earnings. Common stock represents the legal capital of the company. Preferred stock is a sort of share capital which has a preferred right to dividends. Additional paid-up capital represents the cash contributed by the shareholders of the company in excess of the legal capital of the company i.e. the common stock. Accumulated other comprehensive income represents the credits or debits in shareholders' equity which are other than those related to transactions with shareholders, for example credit for revaluation surplus, credits and debits related to translation reserve, changes in fair value of available for sale investments, etc.
Treasury stock is contra-equity account which means that it appears as a deduction from other shareholders' equity accounts and it represents the cost of the company's investment in its own share stock. Retained earnings represent the total earnings of the company retained by the company for reinvestment. It equals the retained earnings of last period plus net income for the period minus dividends paid during the period.
——
Accounts Receivable
——
Direct write-off method does not use any allowance or reserve account. Although the direct write-off method is simple, it has a major drawback. Often it violates the matching principle of accounting because it recognizes bad debt expense which is partly related to previous accounting period. For example if sales are made at the end of accounting year 20X1, bad debts will be realized in the beginning months of accounting year 20X2. Thus the use of direct write-off method would cause deduction of expenses of previous period against revenue of current period which is contrary to the matching principle of accounting. Since this method is not according to GAAP, it not advised to use direct write-off method. Instead, use the allowance method for bad debts.
Shareholders' Equity Shareholders' equity represents the interest of a company's shareholders in the net assets of the company. According to the accounting equation:
Shareholders' equity = Assets − Liabilities On a balance sheet, there is separate section for shareholders' equity which includes its components such as common stock, preferred stock, additional paid-up capital, accumulated other comprehensive income, treasury stock and retained earnings. Common stock represents the legal capital of the company. Preferred stock is a sort of share capital which has a preferred right to dividends. Additional paid-up capital represents the cash contributed by the shareholders of the company in excess of the legal capital of the company i.e. the common stock. Accumulated other comprehensive income represents the credits or debits in shareholders' equity which are other than those related to transactions with shareholders, for example credit for revaluation surplus, credits and debits related to translation reserve, changes in fair value of available for sale investments, etc.
Treasury stock is contra-equity account which means that it appears as a deduction from other shareholders' equity accounts and it represents the cost of the company's investment in its own share stock. Retained earnings represent the total earnings of the company retained by the company for reinvestment. It equals the retained earnings of last period plus net income for the period minus dividends paid during the period.
