Which method of estimating bad debts is required by GAAP when the amount of bad debt is material?

• A. Direct write-off method
• B. Allowance method
• C. Percentage of sales method
• D. Aging of inventory method

Answer: (B)

Verified step by step guidance

1. Understand the concept of bad debts: Bad debts are accounts receivable that are unlikely to be collected. Companies must estimate these amounts to comply with accounting principles.
2. Learn about the direct write-off method: This method records bad debts only when they are confirmed as uncollectible. However, it does not comply with GAAP when bad debts are material because it violates the matching principle.
3. Understand the allowance method: This method estimates bad debts in advance and creates an allowance for doubtful accounts. It complies with GAAP because it matches expenses with revenues in the same period.
4. Explore the percentage of sales method: This is a type of allowance method where bad debts are estimated as a percentage of total sales. It is commonly used but is not the only approach under the allowance method.
5. Clarify the aging of accounts receivable method: This is another type of allowance method where bad debts are estimated based on the age of receivables. Older receivables are more likely to be uncollectible. GAAP requires the allowance method when bad debts are material, and either percentage of sales or aging of accounts receivable can be used within this framework.