Question

Anth Company has significant amounts of trade accounts receivable. Anth uses the allowance method to estimate bad debts. During the year, some specific accounts were written off as uncollectible, and some that were previously written off as uncollectible were collected.

Anth also has some interest-bearing notes receivable for which the face amount plus interest at the prevailing rate of interest is due at maturity. The notes were received on July 1, 2018 and are due on June 30, 2019.

Required:

What are the deficiencies of the direct write-off method?
What are the two basic allowance methods used to estimate bad debts, and what is the theoretical justification for each?
How should Anth account for the collection of the specific accounts previously written off as uncollectible?
How should Anth report the effects of the interest-bearing notes receivable on its December 31, 2018, balance sheet and its income statement for the year ended December 31, 2018? Why?

Answer 1

As we know that

• A bad debt expense is recognized when a receivable is no longer collectible because a customer is unable to fulfill their obligation to pay an outstanding debt. Bad debt expense is an unfortunate cost of doing business with customers on credit, as there is always a default risk inherent to extending credit.
• The direct write-off method records the exact amount of uncollectible accounts as they are specifically identified.Under this method there is no allowance account. Rather, an account receivable is written-off directly to expense only after the account is determined to be uncollectible.
• In order to comply with the matching principle, bad debt expense must be estimated using the allowance method in the same period in which the sale occurs. The allowance method refers to an uncollectible accounts receivable process that records an estimate of bad debt expense in the same accounting period as the sale.

Answer to Part A) Deficiencies of Direct Write off method can be summarised as below:

• Violates Matching Principle- As this method writes off the bad debt when it is actually incurred, it is violating the matching principle. When the sales has taken place, the business books the entire sales as revenue. When the bad debt occurs, which is usually at a later date, the business books it as expense in the P&L account. However, this expense was related to the sales of another earlier period.The matching principle requires a business to record revenues and their related expenses in the same accounting period. Because of this violation, GAAP allows a business to use the direct write-off method only for insignificant amounts.

• Accounts Receivable are misstated: Accounts receivable is an asset on the balance sheet that represents the money customers owe. A business that uses the direct write-off method records the full amount of an account receivable at the time of a sale. But if some of these accounts become uncollectible, the reported accounts receivable balance would be too high. For example, if a small business uses the direct write-off method and reports $50,000 in accounts receivable, the balance can be misleading because the business might collect less than the full $50,000.

• Can be misused: The direct write-off method allows more room for manipulation than other methods. Although a company is supposed to write off an account as soon as it determines the account to be uncollectible, it uses its judgment to decide when that moment arrives. This leeway allows an unethical company to inappropriately manage its profits. For instance, if a business wants to artificially raise its profits, it might overlook some past-due accounts until a later period so it can delay reporting the bad debt expense.

• Profits are not accurately reported: Profit equals revenue minus expenses. Because a bad debt expense sometimes occurs in a later period than its related revenue, a company’s profits on its income statement might be inaccurate. Its profit would be too high when it records the revenue and too low when it records the related bad debt expense. For example, assume your small business records a $5,000 sale in the first quarter and writes that $5,000 off in the second quarter. Your first-quarter profit would be $5,000 too high and your second-quarter profit would be $5,000 too low

Answer to Part b)

As explained in Part A above, the allowance method records an estimate of bad debt expense in the same accounting period as the sale. It often takes months for companies to identify specific uncollectible accounts. The allowance method follows the matching principle, which states revenues need to be matched with the expenses incurred in that same accounting period.

Generally, companies will choose between two approaches under the allowance method.

Percentage of Sales: Using historical data, a company examines the relationship between sales and uncollectible accounts receivable. If there is a fairly stable relationship between the two, a company will use the historical Uncollectible Accounts / Credit Sales ratio to estimate the bad debts expense in the current period.

For example, a company might find a historical trend indicating 2% of credit sales are never collected from customers. If that company had $100,000 of credit sales in the current period, it would also record the following journal entry:

Date	Account	Debit	Credit
3/31/20XX	Bad Debts Expense	$2,000
	Allowance for Doubtful Accounts		$2,000

This method is sometimes referred to as the income statement approach.

Percentage of Accounts Receivable: Using historical data, a company examines the relationship between accounts receivable and uncollectible accounts. Companies will oftentimes increase the accuracy of these estimates by looking at their aging schedule for patterns, rather than using a composite (or total) of their receivables.

For example, a company might find a historical trend indicating 50% of credit sales over 150 days due are never collected, while 0.5% of credit sales over 30 days are never collected. This approach is illustrated below:

Aging Schedule	Bad Debts Estimate	A/R Balance	Allowance for Bad Debts
Over 30 days	0.5%	$300,000	$1,500
31 to 60 days	1.0%	$100,000	$ 1,000
61 to 90 days	2.0%	$50,000	$1,000
91 to 120 days	5.0%	$7,000	$350
120 to 150 days	15.0%	$5,000	$750
Over 150 days	50%	$3,000	$1,500
Total Balance	$6,100

This method is sometimes referred to as the balance sheet approach.

Allowance for bad debt, also known as the allowance for doubtful accounts, is a contra asset account and is used as an offset to accounts receivable. This allows the account to be stated in what is known as net realizable value, where:

Net Realizable Value = Accounts Receivable - Allowance for Doubtful Accounts

Answer to Part c) Anth Company had written certain accounts off as uncollectible. It happens in business, that when we do not expect an amount to be recovered, one fine day, the customer pays its dues.Its called bad debt recovery and its a good news for Anth Co. It has to be recorded in the books of accounts. It is because, when Anth Co. had written off the amount as bad debts, it mustve charged it as an expense in the Profit and Loss account.

The accounting for a bad debt recovery is a two-step process, as follows:

1. Reverse the original recording of a bad debt. This means creating a debit to the accounts receivable asset account in the amount of the recovery, with the offsetting credit to the allowance for doubtful accounts contra asset account. i.e.

   Debit (Dr) Account receivable

   Credit (Cr) Bad debts recovery

2. Record the cash receipt from the bad debt recovery, which is a debit to the cash account and a credit to the accounts receivable asset account.

   Debit (Dr) Cash

   Credit (Cr) Account receivables

Reply to part d) How should Anth report the effects of the interest-bearing notes receivable on its December 31, 2018, balance sheet and its income statement for the year ended December 31, 2018? Why?

It is given in the question that Anth Company also has some interest-bearing notes receivable for which the face amount plus interest at the prevailing rate of interest is due at maturity. The notes were received on July 1, 2018 and are due on June 30, 2019.

The effect in the balance sheet on 31st December 2018

Anth Company must show the notes receivable under the current assets heading. The amount of notes receivable must be calculated after adding the interest for the period of 6 months(July 2018-Dec 2018) to the amount of the note receivable. In the income statement, the amount of interest for the period of 6 months(July 2018-Dec 2018) should be depicted under the Credit side of Income Statement.