At December 31, 2010, the trial balance of Olpe Company contained the following

Question

At December 31, 2010, the trial balance of Olpe Company contained the following amounts before adjustment.

Debits Credits
Accounts Receivable $200,000
Allowance for Doubtful Accounts $ 1,500
Sales 875,000

Instructions

(a) Prepare the adjusting entry at December 31, 2010, to record bad debts expense assuming that the aging schedule indicates that $10,800 of accounts receivable will be uncollectible.

(b) Repeat part (a) assuming that instead of a credit balance there is a $1,500 debit balance in the Allowance for Doubtful Accounts.

(c) During the next month, January 2011, a $2,700 account receivable is written off as uncollectible. Prepare the journal entry to record the write-off.

(d) Repeat part (c) assuming that Olpe Company uses the direct write-off method instead of the allowance method in accounting for uncollectible accounts receivable.

(e)
What are the advantages of using an aging schedule and the allowance method in accounting for uncollectible accounts as compared to the direct write-off method?

Explanation / Answer

It is important to Note that Allowance for Bad Debts has a Credit Balance. (a) 31 Dec 2010 Bad Debts Expense Dr 9300 Allowance for Bad Debts Cr 9300 (Prov for 10800 for Bad debts..Opening Bal is 1500. SO addl (10800-1500 = 9300)) (b) 31 Dec 2010 Bad Debts Expense Dr 12300 Allowance for Bad Debts Cr 12300 (Prov for 10800 for Bad debts..Opening Bal is a Debit Bal of 1500. SO addl (10800+1500 = 12300)) (c) dd Jan 11 Allowance for Bad Debts Dr 2700 Acct Rxable Cr 2700 (account receivable is written off as uncollectible) (d) dd Jan11 Bad Debt Expense Dr 2700 Acct Rxable Cr 2700 (account receivable is written off as uncollectible using Direct write off method) (e) Direct write off method does not conform to the matching principal and therefore is not in compliance with GAAP. This method should only be used when uncollectible invoices can be estimated to be an immaterial amount and the average accounts receivable balance is less than $20,000. Under the direct write off method, a company does not anticipate bad debt expense. Rather, it waits until an account is actually written off as uncollectible before recording bad debt expense. This means its accounts receivable will be reported on the balance sheet at their full amounts—implying that all of the accounts receivable will be turning to cash. If there is some doubt concerning the collectibility of some of the receivables, the assets are potentially overstated and the company’s profit is potentially overstated. Since there is usually a significant amount of time between a credit sale and the write off of a bad account, the bad debt expense will occur in a much later period than the revenue from the sale. This is a problem under the matching principle. Internal Revenue Service requires the direct write off method. They prefer to see the tax deduction for bad debt expense only when an account receivable is actually written off—as opposed to allowing a deduction for an anticipated potential loss. Aloowance for Doubtful Accounts method records receivables recorded but not expected to be collected. Companies with accounts receivable greater than $20,000, not including the allowance, must compute and record an Allowance for Doubtful Accounts on their balance sheet. (This accounts receivable balance should be re-evaluated on an annual basis to determine reporting status.) Often, it is not known which specific accounts receivable invoices will be uncollectible. An allowance is therefore established to estimate the value of those receivables believed to be uncollectible. This entry should be recorded so the income statement and balance sheet are fairly stated at the amount expected to be collected in receivables, thus satisfying the matching principle1. The entry creates a contra accounts receivable balance. When netted against the gross total of accounts receivable, the true value of the receivables is reported. While this allowance method is good for financial reporting, it might not be allowed for income tax purposes.

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