Problem 13 - Accounting

Question

The following selected transactions were taken from the records of Lights of the West Company for the first year of its operations ending December 31, 2010: Jan. 24. Wrote off account of J. Huntley, \(\$ 3,000\). Feb. 17. Received \(\$ 1,500\) as partial payment on the \(\$ 4,000\) account of Karlene Solomon. Wrote off the remaining balance as uncollectible. May 29. Received \(\$ 3,000\) from J. Huntley, which had been written off on January 24 . Reinstated the account and recorded the cash receipt. Nov.30. Wrote off the following accounts as uncollectible (record as one journal entry): \(\begin{array}{lr}\text { Don O'Leary } & \$ 2,000 \\ \text { Kim Snider } & 1,500 \\ \text { Jennifer Kerlin } & 900 \\ \text { Tracy Lane } & 1,250 \\\ \text { Lynn Fuqua } & 450\end{array}\) Dec. 31. Lights of the West Company uses the percent of credit sales method of estimating uncollectible accounts expense. Based on past history and industry averages, \(1 \frac{1}{2} \%\) of credit sales are expected to be uncollectible. Lights of the West Company recorded \(\$ 975,000\) of credit sales during 2010 . a. Journalize the transactions for 2010 under the direct write-off method. b. Journalize the transactions for 2010 under the allowance method. c. How much higher (lower) would Lights of the West Company's net income have been under the direct write-off method than under the allowance method?

Step-by-Step Solution

Answer

Net income is $3,025 lower under the allowance method.

Step 1: Direct Write-Off Method (Journal Entries)

- Jan. 24: Debit Bad Debt Expense, Credit Accounts Receivable (J. Huntley): \[\text{Debit } \quad \text{Bad Debt Expense} \quad \\(3,000 \\text{Credit } \quad \text{Accounts Receivable - J. Huntley} \quad \\)3,000\]- Feb. 17: Debit Bad Debt Expense, Credit Accounts Receivable (Karlene Solomon) for the remaining unpaid amount after partial payment:\[\text{Debit } \quad \text{Bad Debt Expense} \quad \\(2,500 \\text{Credit } \quad \text{Accounts Receivable - Karlene Solomon} \quad \\)2,500\]- May 29: Debit Accounts Receivable, Credit Bad Debt Expense for J. Huntley and record the cash receipt:\[\text{Debit } \quad \text{Accounts Receivable - J. Huntley} \quad \\(3,000 \\text{Credit } \quad \text{Bad Debt Expense} \quad \\)3,000 \\text{Debit } \quad \text{Cash} \quad \\(3,000 \\text{Credit } \quad \text{Accounts Receivable - J. Huntley} \quad \\)3,000\]- Nov. 30: Write off multiple accounts as uncollectible (one journal entry):\[\text{Debit } \quad \text{Bad Debt Expense} \quad \\(6,100 \\text{Credit } \quad \text{Accounts Receivable} \quad \\)6,100\]

Step 2: Allowance Method (Journal Entries)

- Jan. 24: No entry needed until the end of the accounting period adjustments.- Feb. 17: Write-off the remainder of Karlene Solomon’s account:\[\text{Debit } \quad \text{Allowance for Doubtful Accounts} \quad \\(2,500 \\text{Credit } \quad \text{Accounts Receivable - Karlene Solomon} \quad \\)2,500\]- May 29: Reinstate and collect J. Huntley’s account:\[\text{Debit } \quad \text{Accounts Receivable - J. Huntley} \quad \\(3,000 \\text{Credit } \quad \text{Allowance for Doubtful Accounts} \quad \\)3,000 \\text{Debit } \quad \text{Cash} \quad \\(3,000 \\text{Credit } \quad \text{Accounts Receivable - J. Huntley} \quad \\)3,000\]- Nov. 30: Write off uncollectible accounts:\[\text{Debit } \quad \text{Allowance for Doubtful Accounts} \quad \\(6,100 \\text{Credit } \quad \text{Accounts Receivable} \quad \\)6,100\]- Dec. 31: Record uncollectible expense based on credit sales:\[\text{Debit } \quad \text{Bad Debt Expense} \quad \\(14,625 \\text{Credit } \quad \text{Allowance for Doubtful Accounts} \quad \\)14,625\] *(Note: \(14,625 calculated as \)975,000 x 1.5%)*

Step 3: Compare Net Income Under Both Methods

Under the direct write-off method, total bad debts recognized amounted to:\[3,000 + 2,500 + 6,100 = \\(11,600\]Under the allowance method, the total expense is based on the 1.5% estimate of credit sales:\[14,625\]The difference affecting net income is:\[\\)11,600 - \\(14,625 = -\\)3,025\]Thus, net income is lower by $3,025 under the allowance method compared to the direct write-off method.

Key Concepts

Direct Write-Off Method

The direct write-off method is a straightforward approach to handling uncollectible accounts in accounting. In this method, bad debts are written off directly against income when they become clearly uncollectible. This is done by debiting Bad Debt Expense and crediting Accounts Receivable. Although simple, one of the downsides of this method is timing, as it recognizes bad debt only when it is deemed uncollectible, which may not align with the period in which the sale was made.
This method is typically not preferred under Generally Accepted Accounting Principles (GAAP) because it can misstate the financial health of a company within financial periods. However, small businesses might use it due to its ease and simplicity when handling minimal bad debts.

Allowance Method

The allowance method offers a more systematic approach to handling uncollectible accounts through the estimation of potential losses. At the end of a financial period, businesses estimate bad debt expenses and set aside reserves for doubtful accounts by debiting the Bad Debt Expense and crediting the Allowance for Doubtful Accounts.
This approach aligns expenses with revenues, adhering to the matching principle in accounting. The allowance method enhances the accuracy of financial statements. It requires frequent adjustments to reflect the anticipated losses based on historical data or industry norms. This method is often used by larger businesses and is preferred under GAAP.

Uncollectible Accounts

Uncollectible accounts refer to money that a company is unable to collect from its customers. This can occur for various reasons, such as bankruptcy or financial difficulties faced by the customers. Handling uncollectible accounts efficiently is crucial, as they directly impact a company's revenue and financial planning.
Companies typically use either the direct write-off method or the allowance method to manage these losses. Both methods involve recording losses due to uncollected debts, but they differ significantly in their application and impact on financial statements. Efficient management of these accounts ensures accurate financial reporting and planning.

Net Income Comparison

When comparing the net income results under the direct write-off method and the allowance method, a notable difference often arises. This is because the direct write-off method recognizes the expense only at the point of uncollectibility, which could be in a different financial period than the revenue.
In the given exercise, the net income reported is higher under the direct write-off method by $3,025. This occurs because the allowance method estimates potential bad debts in advance, considering historical data, thus recognizing higher expenses within the same period as related revenues. This comparison highlights the relevance of selecting an appropriate accounting method based on the company's reporting needs and financial activities.