Problem 18 - Accounting

Question

OK International wrote off the following accounts receivable as uncollectible for the year ending December 31, 2010: \begin{tabular}{lr} Customer & Amount \\ \hline Eva Fry & \(\$ 6,500\) \\ Lance Landau & 11,200 \\ Marcie Moffet & 3,800 \\ Jose Reis & 3,500 \\ Total & \(\$ 25,000\) \\ \hline \end{tabular} The company prepared the following aging schedule for its accounts receivable on December 31, 2010: \begin{tabular}{lrc} Aging Class (Number of Days Past Due) & Receivables Balance on December 31 & Estimated Percent of Uncollectible Accounts \\ \hline \(0-30\) days & \(\$ 480,000\) & \(1 \%\) \\ \(31-60\) days & 100,000 & 3 \\ \(61-90\) days & 40,000 & 20 \\ \(91-120\) days & 25,000 & 30 \\ More than 120 days & 5,000 & 40 \\ Total receivables & \(\$ 650,000\) & \end{tabular} a. Journalize the write-offs for 2010 under the direct write-off method. b. Journalize the write-offs and the year-end adjusting entry for 2010 under the allowance method, assuming that the allowance account had a beginning balance of \(\$ 22,500\) on January 1, 2010, and the company uses the analysis of receivables method.

Step-by-Step Solution

Answer

Direct write-off method records bad debt as an expense. Under the allowance method, adjust the allowance account and make an adjusting entry based on estimated uncollectibles.

Step 1: Journalize Write-offs Under Direct Write-Off Method

For the direct write-off method, write-offs are directly recorded as bad debt expense. We will create a journal entry for each uncollectible account. The journal entry for each customer is:- **Eva Fry:** - Debit Bad Debt Expense: \(6,500\) - Credit Accounts Receivable: \(6,500\)- **Lance Landau:** - Debit Bad Debt Expense: \(11,200\) - Credit Accounts Receivable: \(11,200\)- **Marcie Moffet:** - Debit Bad Debt Expense: \(3,800\) - Credit Accounts Receivable: \(3,800\)- **Jose Reis:** - Debit Bad Debt Expense: \(3,500\) - Credit Accounts Receivable: \(3,500\)

Step 2: Calculate Estimated Uncollectible Amount Using Aging Schedule

To adjust for the allowance method, calculate the estimated uncollectible accounts. Use the aging schedule to find the total estimated bad debt:- **0-30 days:** \(480,000 \times 0.01 = 4,800\)- **31-60 days:** \(100,000 \times 0.03 = 3,000\)- **61-90 days:** \(40,000 \times 0.20 = 8,000\)- **91-120 days:** \(25,000 \times 0.30 = 7,500\)- **More than 120 days:** \(5,000 \times 0.40 = 2,000\)Add the amounts to get the total estimated uncollectible:\[4,800 + 3,000 + 8,000 + 7,500 + 2,000 = 25,300\]

Step 3: Journalize Write-offs and Adjusting Entry Under Allowance Method

For the allowance method, first record the write-off entries, removing the uncollectible accounts from the books using the Allowance for Doubtful Accounts:- **Eva Fry:** - Debit Allowance for Doubtful Accounts: \(6,500\) - Credit Accounts Receivable: \(6,500\)- **Lance Landau:** - Debit Allowance for Doubtful Accounts: \(11,200\) - Credit Accounts Receivable: \(11,200\)- **Marcie Moffet:** - Debit Allowance for Doubtful Accounts: \(3,800\) - Credit Accounts Receivable: \(3,800\)- **Jose Reis:** - Debit Allowance for Doubtful Accounts: \(3,500\) - Credit Accounts Receivable: \(3,500\)For the year-end adjusting entry, determine the needed adjustment in the Allowance account. Start with the beginning balance, subtract the total amount written off, and compare to the required balance:1. **Beginning Balance:** \(22,500\)2. **Total Write-offs:** \(25,000\)3. **Required Balance based on Estimate:** \(25,300\)So, the adjustment is \(25,300 - (22,500 - 25,000) = 27,800\) needed in the Allowance account.Make the adjusting entry:- **Adjustment Entry:** - Debit Bad Debt Expense: \(27,800\) - Credit Allowance for Doubtful Accounts: \(27,800\)

Key Concepts

Direct Write-Off Method

The direct write-off method is a straightforward accounting technique used to account for bad debts. Under this method, a business records the actual amount of an account that is considered uncollectible directly as a bad debt expense, at the point it becomes evident that the debt will not be collected.
This method is straightforward but doesn't adhere to the matching principle of accounting because it typically recognizes bad debt expense in a different period than when the revenue was earned. Here’s how it works: when you identify a specific account that can't be collected, you directly write it off by debiting the bad debt expense account and crediting accounts receivable.
Think of it as a specific correction made each time a debt issue arises. This approach is easy but may not reflect the most accurate picture of a company's financial status, especially if uncollectible amounts are significant.

Allowance Method

The allowance method involves estimating uncollectible accounts at the end of each period. This technique complies with the matching principle by associating bad debt expenses with the revenues they helped generate, even if those debts turn uncollectible later.
There are two main ways to estimate bad debts using the allowance method:

• Percentage of sales
• Aging of accounts receivable, which we'll explain further in another section

With this method, companies record an adjusting entry at the end of the accounting period. This involves crediting an allowance for doubtful accounts, a contra asset account, and debiting bad debt expense. When a specific account is identified as uncollectible, the company debits the allowance for doubtful accounts and credits accounts receivable.
Essentially, the allowance method anticipates potential losses, preserving the integrity of an organization's financial statements.

Aging Schedule

The aging schedule is a tool used to categorize receivables based on the length of time an invoice has been outstanding. This helps businesses estimate the probability of not collecting the receivables. By dividing debt into age groups, companies can more accurately estimate which debts might go uncollected.
A typical aging schedule separates accounts into categories such as 0-30 days, 31-60 days, etc. Each category may have a corresponding percentage that represents the likelihood of the accounts in that category being uncollectible. These percentages are based on historical data or industry standards.
For instance, an aging schedule might show:

• 0-30 days: 1% uncollectible
• 31-60 days: 3% uncollectible

Using this schedule, companies can calculate a more accurate allowance for doubtful accounts. This not only aids in proper financial reporting but in assessing and managing credit risk.

Journal Entries

Journal entries are essential components of keeping accurate financial records, acting as the official and chronological accounting report for financial transactions in a double-entry bookkeeping system.
When writing off bad debts, journal entries can vary depending on whether you're using the direct write-off method or the allowance method. For instance, under the direct write-off method, you would make an entry as follows:

• Debit: Bad debt expense (to increase the expense)
• Credit: Accounts receivable (to decrease the asset)

This highlights the expense being recognized when the debt is identified as uncollectible.
In contrast, under the allowance method, journal entries include adjusting entries at the period end for estimated uncollectibles. A typical entry would be:

• Debit: Bad debt expense (to reflect estimated potential losses)
• Credit: Allowance for doubtful accounts (to create a reserve for future bad debts)

These ensure that financial statements accurately reflect potential risks, keeping records aligned with accounting principles.