Question

In: Accounting

Historically, your company has calculated bad debts using an aging of accounts receivable. Near the end...

Historically, your company has calculated bad debts using an aging of accounts receivable. Near the end of the fiscal year, the company is in a cash crunch and needs to borrow money from the bank, using accounts receivable as collateral. The owner of the company knows that many of the accounts receivable are more than 90 days past due, resulting in net receivables equal to only 80% of total receivables.

Respond to the following in a minimum of 175 words:

  • The owner asks you to change the method of estimating bad debts to a flat 3% of receivables. What should you do?

Solutions

Expert Solution

The method of estimating the bad debts as percentage of accounts receivable should not be changed. Accounts receivable are part of current assets and they should be valued at net realisable value. Net realisable value refers the carrying value of receivable less allowance for doubtful debts. Ensuring valuation of Accounts receivable at net realisable value gives a true and fair view of the financial statements of the firm.

In the given situation the allowance for uncollectible accounts are provided for at the end of the period based on percentage of aging of accounts receivable. Lowering the percentage from 20% to 3% will result in lower allowance for uncollectible accounts and will show higher net income for the period. The higher net income is shown for the purpose of bank loan since financial statements have to be submitted to bank for obtaining loan. This practice is compromise on integrity and is not advisable since it is against the principle of accounting because accounts receivable is not valued at net realisable value. As per principle of conservatism all estimated losses should be provided in financial statements based on best estimates available.


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