Question

Clark Pierce conducts a wholesale merchandising business that sells approximately 5,000 items per month with a total monthly average sales value of $250,000. Its annual bad debt rate has been approximately 1½% of sales. In recent discussions with his bookkeeper, Mr. Pierce has become confused by all the alternatives apparently available in handling the Allowance for Doubtful Accounts balance. The following information has been presented to Pierce.

1. An allowance can be set up (a) on the basis of a percentage of receivables or (b) on the basis of a valuation of all past due or otherwise questionable accounts receivable. Those considered uncollectible can be charged to such allowance at the close of the accounting period, or specific items can be charged off directly against (1) Gross Sales or to (2) Bad Debt Expense in the year in which they are determined to be uncollectible.

2. Collection agency and legal fees, and so on, incurred in connection with the attempted recovery of bad debts can be charged to (a) Bad Debt Expense, (b) Allowance for Doubtful Accounts, (c) Legal Expense, or (d) Administrative Expense.

3. Debts previously written off in whole or in part but currently recovered can be credited to (a) Other Revenue, (b) Bad Debt Expense, or (c) Allowance for Doubtful Accounts.

Instructions

Which of the foregoing methods would you recommend to Mr. Pierce in regard to (1) allowances and charge-offs, (2) collection expenses, and (3) recoveries? State briefly and clearly the reasons supporting your recommendations.

Short answer

1. Allowance and charge-off method: (a).

2. Collection expenses: (a) or (b).

3. Recovery of bad debts: (c).

Step-by-step solution

Definition of Bad Debts Recovered

Bad Debt recovered includes the amount of money previously estimated to be uncollectible and reported as bad debt, but now it is collected from the customer.

Method to be Adopted

1. Allowance and charge-off method: The business entity has a large number of sales transactions, and therefore, it is recommended to use method (a) for setting up allowance. The business entity must estimate the allowance as a percentage of receivables and report accounts receivables at their net realizable value. Following such a method will fairly represent the balance sheet amounts and comply with the matching principle.

2. Collection expenses: The business entity must adopt method (a) or (b). The bad debt account of the business entity must reflect every expense incurred by the business entity in collecting the receivables, whether they are recovered or not.

The business entity can also adopt method (b) because all related expenses are included in the bad debt expenses during the first establishment of the allowance account. Therefore, estimation of the allowance account already includes all of these expenses, and therefore, it is advisable to charge such expenses against the allowance account.

3. Recovery of bad debts: The business entity must adopt method (c). Adopting such a method will correct the written-off bad debts and increase the accounts receivables of the business entity. Another reason for adopting method (c) is that all companies are advised to re-establish the accounts receivable’s balance.