91Ó°ÊÓ

The following selected transactions were taken from the records of Shaw Company for the first year of its operations ending December 31, 2008: Jan. 31. Wrote off account of B. Roberts, \(2,400. Mar. 26. Received \)1,500 as partial payment on the \(3,500 account of Carol Castellino. Wrote off the remaining balance as uncollectible. July 7. Received \)2,400 from B. Roberts, which had been written off on January 31. Reinstated the account and recorded the cash receipt. Oct. 12. Wrote off the following accounts as uncollectible (record as one journal entry): Julie Lindley \(1,350 Mark Black 950 Jennifer Kerlin 525 Beth Chalhoub 1,125 Allison Fain 725 Dec. 31. Shaw Company uses the percent of credit sales method of estimating uncollectible accounts expense. Based upon past history and industry averages, 2% of credit sales are expected to be uncollectible. Shaw recorded \)750,000 of credit sales during 2008. a. Journalize the transactions for 2008 under the direct write-off method. b. Journalize the transactions for 2008 under the allowance method. c. How much higher (lower) would Shaw’s 2008 net income have been under the direct write-off method than under the allowance method?

Step by step solution

01

Direct Write-Off Method - Journalize Transactions

Under the direct write-off method, we record bad debt expenses only when accounts are deemed uncollectible, rather than estimating them in advance. - **January 31:** Write-off B. Roberts account: Debit: Bad Debt Expense $2,400 Credit: Accounts Receivable - B. Roberts $2,400 - **March 26:** Partial payment from Carol Castellino: Debit: Cash $1,500 Debit: Bad Debt Expense $2,000 Credit: Accounts Receivable - Carol Castellino $3,500 - **July 7:** Reinstating and receiving payment from B. Roberts: Debit: Accounts Receivable - B. Roberts $2,400 Credit: Bad Debt Expense $2,400 Debit: Cash $2,400 Credit: Accounts Receivable - B. Roberts $2,400 - **October 12:** Write-off uncollectible accounts: Debit: Bad Debt Expense $4,675 Credit: Accounts Receivable $4,675

02

Allowance Method - Journalize Transactions

The allowance method involves estimating uncollectible accounts at the beginning or end of each period and recording bad debt expenses and the allowance for doubtful accounts. - **December 31:** Estimate the allowance for doubtful accounts at 2% of credit sales: Debit: Bad Debt Expense $15,000 (2% of $750,000) Credit: Allowance for Doubtful Accounts $15,000 - **January 31, March 26, July 7, October 12:** Record specific transactions by adjusting and using the allowance account: We credit 'Accounts Receivable' and debit 'Allowance for Doubtful Accounts' instead of 'Bad Debt Expense' since it records previously estimated bad debts.

03

Compare Net Income Impact

The difference in net income under the two methods occurs because expenses are reported at different times. - **Direct Write-Off Method:** Bad debts are recorded only when identified as uncollectible, resulting in $7,075 recorded for 2008. - **Allowance Method:** Based on sales, $15,000 of bad debts are recorded as an expense. Shaw's net income under the direct write-off method is therefore $7,925 higher compared to the allowance method for 2008.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Direct Write-Off Method

The direct write-off method is a simple way to handle accounts that cannot be collected. In this method, you only record a bad debt expense when you have confirmed that an account is uncollectible. There's no estimation involved, so it doesn’t require setting aside an allowance for doubtful accounts in advance.

When money owed by a customer is found to be uncollectible, companies debit (or increase) the Bad Debt Expense account. Similarly, they credit (or reduce) the Accounts Receivable account associated with that particular customer. This method affects your net income only at the time of writing off the account.

• Pros: Simple to apply since there’s no need for estimates.
• Cons: Doesn’t match revenues with expenses effectively, violating the matching principle in accounting.

This method may also fail to provide an accurate representation of an organization’s financial position for each period.

Allowance Method

The allowance method provides a way to estimate and record bad debt expenses in advance. It aligns with the accounting principle that calls for matching revenues with expenses in the same period. Companies use historical data to estimate the amount of future uncollectible accounts.

This method employs an "Allowance for Doubtful Accounts" - a contra-asset account. A company debits Bad Debt Expense, which signifies the estimated cost of uncollectible accounts, and credits the Allowance for Doubtful Accounts.

• Pros: Provides a more accurate estimate of net realizable accounts receivable, improving period-end financial reporting.
• Cons: More complex due to estimation and requires regular adjustments.

By predicting future uncollectibles, companies can mitigate the impact on future periods' net income.

Bad Debt Expense

A bad debt expense represents the cost to an organization for extending credit that is deemed uncollectible. It is an expense that becomes necessary when a business realizes that a customer has defaulted on payment.

For accounting purposes, there are two main approaches to recording bad debt expenses:

• **Direct write-off method**: Recognizes bad debt as an expense only when an account is deemed uncollectible.
• **Allowance method**: Estimates bad debt at the end of an accounting period, allowing companies to reflect potential future losses in the same period as the associated revenues.

It’s crucial for businesses to account for bad debts to avoid overstating their assets and net income. Proper management can be a significant determinant of a company's financial health.

Uncollectible Accounts

Uncollectible accounts, also known as bad debts, are amounts owed by customers that are considered unlikely to be collected. These accounts may occur due to a customer's financial difficulties or other reasons that inhibit payment.

Handling these accounts efficiently is important as they affect both the balance sheet and income statement. When identifying uncollectible accounts, businesses have two primary options for action:

• Writing off: Directly removing the accounts from books if using the direct write-off method.
• Adjusting: Using the allowance method to adjust an existing allowance account, providing a cushion for anticipated credit losses.

Recognizing and handling uncollectible accounts timely helps in maintaining accurate financial records, allowing businesses to make informed decisions.

Financial Statements

Financial statements are formal records that detail the financial activities and position of a business, individual, or entity. These documents are crucial for stakeholders to assess the financial performance and condition of a business.

For companies dealing with credit sales, one key aspect that affects financial statements is the handling of bad debts. Depending on whether a business uses the direct write-off or allowance method, the timing and amount of bad debt expense recorded can vary, significantly impacting financial statements like:

• **Income Statement**: Bad debts reduce net income, with large discrepancies based on the estimation and writing-off of bad debts.
• **Balance Sheet**: The allowance method typically shows a reduced net accounts receivable, affecting a company's liquitity view.

Understanding how these methods affect financial statements is crucial for accurate reporting and for stakeholders to make sound financial decisions.