Question

Net sales for the month are \(\$ 800,000\), and bad debts are expected to be \(1.5 \%\) of net sales. The company uses the percentage-of-sales basis. If Allowance for Doubtful Accounts has a credit balance of \(\$ 15,000\) before adjustment, what is the balance after adjustment? a. \(\$ 15,000\). c. \(\$ 23,000\). b. \(\$ 27,000\). d. \(\$ 31,000\).

Short answer

The adjusted balance is $27,000.

Step-by-step solution

Calculate the Expected Bad Debts

First, we need to determine the amount of bad debts expected. The company expects bad debts to be 1.5% of net sales. Given net sales are \(\\( 800,000\), we calculate \(1.5\%\) of \(\\) 800,000\):\[\text{Bad Debts} = 0.015 \times 800,000 = \$ 12,000\]

Determine Balance Before Adjustment

The Allowance for Doubtful Accounts has a current credit balance of \(\$ 15,000\) before any adjustment is made. This is the starting point for the allowance account.

Adjust Allowance for Doubtful Accounts

According to the percentage-of-sales method, the bad debts must be recorded as an expense, increasing the Allowance for Doubtful Accounts by the amount calculated in Step 1.\[\text{New Allowance Balance} = \text{Initial Balance} + \text{Bad Debts} = 15,000 + 12,000 = \$ 27,000\]

Key concepts

Net Sales

Net sales is a key financial metric for any business. It represents the total revenue from goods sold or services provided, minus any returns, allowances, and discounts. It's important because it provides a clear picture of the actual revenue earned by a company during a particular period. In the context of accounting and bookkeeping, net sales serve as the foundation for calculating other important financial figures. For example:

• Gross profit, derived by subtracting cost of goods sold from net sales.
• Net income, determined by further subtracting operational expenses and taxes.

In our exercise, the net sales are specified as $800,000. This amount signifies the actual earnings before considering potential uncollected debts, which we address next.

Percentage-of-Sales Method

The Percentage-of-Sales Method is a common accounting technique used to estimate uncollectible accounts or bad debts based on a percentage of total sales. This method assumes that a certain percentage of the company's net sales will turn into uncollectible accounts, allowing businesses to anticipate and plan for these losses. Steps to Implement:

• Determine your net sales for the period.
• Apply the predetermined percentage for bad debts to these net sales.
• Use the resulting figure to adjust your allowance for doubtful accounts.

In our context, if we take 1.5% of net sales—$800,000 in this case—we get $12,000. This amount is the anticipated bad debt expense for the period.

Bad Debts

Bad debts are amounts owed to a company that are unlikely to be paid. These can arise because customers face financial difficulties or disputes over products and services. Accounting for bad debts is crucial for accurately representing a company’s financial health. Significance:

• Not accounting for bad debts can lead to an overstatement of assets and net income.
• Helps in evaluating the efficiency of a company’s credit policies.

In the exercise, $12,000 is anticipated as bad debt. This indicates an expectation that some accounts receivable will not be collectible, and thus an expense is recorded to prepare for these potential losses.

Adjustment

An adjustment in accounting refers to changes made to account balances to reflect more accurately the financial position of a company. Adjustments are vital to ensuring the financial statements are up-to-date at the end of an accounting period. How to Adjust for Bad Debts:

• Record the expected bad debts as an expense, increasing the Allowance for Doubtful Accounts.
• Ensure that this adjustment is made against the current balance to yield the correct end balance.

In this exercise, the allowance for doubtful accounts initially had a balance of $15,000. After recording the $12,000 bad debt expense, the new balance becomes $27,000, reflecting these expected collection losses. This adjustment ensures that the financial statements provide a realistic picture of collectible receivables.