debt and shareholders.docx

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22 Apr 2012
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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.
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