Problem 15 - Accounting

Question

During its first year of operations, Master Plumbing Supply Co. had net sales of \(\$ 3,500,000\), wrote off \(\$ 50,000\) of accounts as uncollectible using the direct write-off method, and reported net income of \(\$ 390,500\). Determine what the net income would have been if the allowance method had been used, and the company estimated that \(13 / 4\) of net sales would be uncollectible.

Step-by-Step Solution

Answer

The net income would be $326,750 with the allowance method.

Step 1: Understand the Direct Write-off Method

The direct write-off method writes off bad debts as they are identified. In this problem, the company directly wrote off $50,000 as uncollectible. The net income provided ($390,500) already accounts for this write-off method.

Step 2: Understand the Allowance Method

The allowance method estimates bad debts at the start of the accounting period and adjusts for it throughout the year. Here, the bad debt is estimated as a portion of net sales. According to the problem, the company should estimate \(\frac{13}{4}\) \% of net sales to be uncollectible.

Step 3: Calculate the Estimated Uncollectible from Net Sales

Calculate the estimated uncollectible amount based on net sales: \[ \frac{13}{4} \times \frac{1}{100} \times 3,500,000 = 0.0325 \times 3,500,000 = 113,750 \] This is the amount that would be set aside as allowance for doubtful accounts using the allowance method.

Step 4: Adjust for Allowance Method

Subtract the estimated allowance for doubtful accounts from net sales to find the adjusted net income. Since this is the first year of operations, the entire estimated amount is considered: \[ \text{Adjusted Net Income} = 390,500 - 113,750 + 50,000 = 326,750 \] The $50,000 originally written off using direct write-off is added back because the allowance method sets aside a different amount.

Key Concepts

Direct Write-off Method

The direct write-off method is a straightforward way to handle bad debts in accounting. With this method, a business waits until it definitively determines certain receivables as uncollectible. Once identified, these specific amounts are directly written off from the accounts as a bad debt expense. This process simplifies accounting, as it only affects the financial records when a debt is declared uncollectible. For instance, in the case of Master Plumbing Supply Co., the company wrote off $50,000 once they realized these accounts wouldn't be collected. This amount has already been accounted for in the net income of $390,500. However, the drawback of this method is its impact on financial statements. Since the write-offs are not predictable, they don't match the revenues of the same period, potentially distorting net income and not adhering to the matching principle in accounting. It might result in misleading financial snapshots because the expenses are recorded in periods after the revenue has been realized.

Allowance Method

Unlike the direct write-off method, the allowance method involves estimating uncollectible accounts during the accounting period. Businesses set up an allowance for doubtful accounts, which serves as an estimation of the debts that may likely go unpaid. This is more proactive and aligns with the matching principle by anticipating potential losses.In our problem, Master Plumbing Supply Co. should set up an allowance based on the estimation that 3.25% of its net sales (\( \frac{13}{4} \%\)) will be uncollectible. This means they anticipate about \(113,750 of bad debts from their \\) 3,500,000 net sales. The allowance method considers adjustments beforehand, allowing a more accurate portrayal of financial health. It spreads the bad debt expense across the periods the sales occur, helping to create a consistent reflection of income and expenses in financial statements. This ensures the impact of bad debts is less erratic, hence offering a stable view of the company's net income over time.

Net Income Calculation

Net income calculation using the allowance method changes significantly from using the direct write-off method. The original net income for Master Plumbing Supply Co. was \( \\( 390,500\). To adjust this figure according to the allowance method, we incorporate our estimated uncollectible amount of \( \\) 113,750\). Since the company initially wrote off \( \\( 50,000\) under the direct method, we add it back to the net income, as they are adjusting to a new estimation plan.Here’s the calculation step-by-step:

• Start with the initially reported net income: \( \\) 390,500\)
• Subtract the new allowance estimate: \( 390,500 - 113,750 = 276,750\)
• Add back the write-off amount: \( 276,750 + 50,000 = 326,750\)

So, by using the allowance method, Master Plumbing Supply Co.'s adjusted net income would be \( \$ 326,750\). This reflection shows the more consistent application of accounting principles and potentially provides a better overview of the financial results to investors.