Which of the following best describes the effect of bad debts on revenue recognition under the accrual basis of accounting?

• A. Bad debts are recognized as a reduction in cash received, not as an expense.
• B. Bad debts do not affect revenue recognition; revenue is recognized when earned, and bad debts are recorded as an expense.
• C. Bad debts are only recognized when cash is collected from customers.
• D. Bad debts reduce the amount of revenue recognized at the time of sale.

Answer: (B)

Verified step by step guidance

1. Understand the concept of revenue recognition under the accrual basis of accounting. Revenue is recognized when it is earned, regardless of when cash is received.
2. Learn about bad debts. Bad debts occur when a customer fails to pay the amount owed, and the company determines that the receivable is uncollectible.
3. Under the accrual basis, bad debts are recorded as an expense in the period they are identified, not as a reduction in revenue. This is because revenue is recognized when earned, and bad debts are a separate issue related to collectability.
4. Bad debts are accounted for using methods such as the allowance method or direct write-off method. These methods ensure that the expense is recorded appropriately without affecting the revenue recognized.
5. Conclude that bad debts do not affect revenue recognition. Revenue is recognized independently of the collectability of receivables, and bad debts are treated as an expense in the financial statements.