Allowance for doubtful accounts: which method is described correctly?

• A. Percentage-of-sales estimates allowance based on aging of receivables.
• B. Aging method estimates bad debt expense based on revenue.
• C. Percentage-of-sales estimates bad debt expense based on revenue; aging method estimates the allowance based on AR aging.
• D. Aging method ignores collectability.

Answer: (C)

The key idea is that there are two standard ways to estimate doubtful accounts, and they address different parts of the financial statements. The correct description uses both: the percentage-of-sales method estimates bad debt expense based on revenue, while the aging of receivables method estimates the allowance for doubtful accounts based on the aging of accounts receivable.

With the percentage-of-sales approach, you take a set percentage of credit sales for the period and record that amount as bad debt expense. This increases the allowance for doubtful accounts and ties the expense to the period’s revenue, which is why it’s often described as an income-statement method.

With the aging method, you examine receivables by how long they have been outstanding and apply different estimated uncollectible percentages to each age bucket. This yields the required ending balance for the allowance account on the balance sheet. The actual bad debt expense for the period is the change in the allowance from the beginning to the end of the period (plus any recoveries or write-offs, if applicable).

For example, if you start with an allowance of 5,000 and the aging analysis indicates the ending allowance should be 8,000, you would recognize 3,000 of bad debt expense this period to bring the allowance up to 8,000.

This is why the described combination is correct: one method estimates expense based on revenue, and the other method estimates the allowance based on AR aging. The aging method does not ignore collectability; it directly reflects it through the aging-based estimates.