Question

You are the owner of a lawn service company (LawnCo) which provides grounds and maintenance services to a range of corporate customers. Customers are expected to pay on the first of each month, in advance of receiving services. One of your corporate customers is an eldercare facility whose grounds you have maintained for many years. The customer has not paid for the last three months of services (from Oct.–Dec. 2020); nevertheless, to maintain a positive relationship, your company continued to provide mowing and weed control services to the eldercare facility during that time. Your company ceased providing services in January 2021 and found out in that same month that the eldercare facility filed for bankruptcy in September. Your company now believes that collection of the missed payments is extremely unlikely.  Your company has already issued financial statements to lenders (for the period ending 12/31/20) which reflected revenue and a corresponding account receivable related to this customer of $10,000 per month for services provided to this customer. Those financial statements also reflected the company’s standard allowance (reserve) amount on receivables, of 4% of sales. In total, your company’s average monthly sales amount to $500,000.

Required:

1. Evaluate whether receipt of this information indicates you have a change in accounting estimate or whether the customer’s bankruptcy should result in this event being considered an error in previously issued financial statements.

2. Next, describe the accounting treatment (as required by the Codification) for each alternative, then support your explanations with draft journal entries.

3. Finally, briefly state which treatment appears to be more appropriate given the circumstances. If you must make any assumptions in reaching this conclusion, state these.

Answer 1

Accounting Estimates:

Due to uncertainties involved in the business, many items in financial statements cannot be measured with precision. It involves judgements based on the latest information available. They are called accounting estimates. Estimates may require bad debts, inventory obsolescence, the fair value of financial assets and liability, the useful life of depreciable assets, etc. It may need to review changes in the circumstances of such an estimate or as a result of new information.

Prior Period Errors:

Prior Period errors are omissions or misstatement in financial statements for one or more prior period arising from failure to use, or misuse of, reliable information that was available when financial statements for those periods were approved for the issue and could reasonably be expected to have been obtained and taken into account in preparation and presentation of those financial statements. Such errors include the effects of mathematical errors, errors in the application of accounting policies, misinterpretations of facts, fraud.

1. Evaluate whether receipt of this information indicates you have a change in accounting estimate or whether the customer’s bankruptcy should result in this event being considered an error in previously issued financial statements:

The customer (eldercare facility) has not paid for the last three months of services (from Oct.-Dec. 2020). To maintain a positive relationship, Lawn company continued to provide mowing and weed control services to the eldercare facility during that time.

Lawn company ceased providing services in January 2021 and found out in the same month that the Eldercare facility filed for bankruptcy in September 2020.

So Fact information that the eldercare facility filed for bankruptcy was available in September 2020 and it should have been taken into account while preparing financial statements for the period ending 12/31/2020. It is, therefore, an error in previously issued financial statements.

2. Next, describe the accounting treatment (as required by the Codification) for each alternative, then support your explanations with draft journal entries:

The customer (eldercare facility) has not paid for the last three months of services (from Oct.-Dec. 2020). So Fact information that the eldercare facility filed for bankruptcy was available in September 2020 and it should have been taken into account while preparing financial statements for the period ending 12/31/2020. It is, therefore, an error in previously issued financial statements.

Lawn company has reflected revenue and a corresponding accounts receivable related to the eldercare facility of $ 30,000 [$10,000 per month *3 months (Oct-Dec 2020)]. Which is 6% of total sales revenue ($ 30,000 / $500,000). This error in the previous period is material.

All material errors in the preceding period should be corrected retrospectively. Here $ 30,000 of eldercare facility has failed to meet revenue recognition criteria due to bankruptcy filed by the eldercare facility in September 2020 itself. Such income recognized should be reversed.

Journal Entry
Sales Revenue	Debit
Accounts Receivable	Credit

3. Finally, briefly state which treatment appears to be more appropriate given the circumstances. If you must make any assumptions in reaching this conclusion, state these:

It is more appropriate to consider it as a prior period error because company has recognized 6% of total revenue which is not fulfilling revenue recognition criteria due to bankruptcy filed by the customer.

Assumption:

When any customer files bankruptcy, Company should stop recognizing its revenue immediately and any error in this regard should be corrected retrospectively.