Magrath Company has an operating cycle of less than one year and provides credit

Question

Magrath Company has an operating cycle of less than one year and provides credit terms for all of its customers. On April 1, 2013, the company factored, without recourse, some of its accounts receivable. Magrath transferred the receivables to a financial institution, and will have no further association with the receivables. Magrath uses the allowance method to account for uncollectible accounts. During 2013, some accounts were written off as uncollectible and other accounts previously written off as uncollectible were collected.

Required: 1. How should Magrath account for and report the accounts receivable factored on April 1, 2013? Why is this accounting treatment appropriate?

2. How should Magrath account for the collection of the accounts previously written off as uncollectible?

3. What are the two basic approaches to estimating the uncollectible accounts under the allowance method? What is the rationale for each approach

Explanation / Answer

Answer 1. In Allowance Method, there are three types of transactions when Accounts Receivables are Value Using the Allowance Method: 1. Estimate uncollectible accounts receivable are recorded at the end of the period by debiting Bad debts expense and Crediting Allowance for Doubtful Debts. The Amount can be determined by using a percentage of total receivables or an aging schedule. This entry is an adjusting entry that is made at the end of the year. The Journal entry is Bad Debt Exp.                                            Dr. Estimated Amount of Accounts Receivables Uncollectible    To Allowance for Doubtful Debts 2. Actual uncollectibles or write offs are then debited to Allowance for Doubtful accounts and credited to Accounts Receivables. This entry is not an adjusting entry and is recorded as soon as it can be determined that the accounts receivables collection is unlikely. The Journal entry is Allowance for Doubtful Debts                   Dr. Actual Amount of Accounts Receivables Uncollectible    To Accounts Receivables Accounting Treatment is Approprate due to follwing reasons: 1. If Bad Debts Expense / Amt. of Allowance for Dountful debts is not estimated by Magrath Company, then it is against the rule of Accrual method of Accounting. Also, the expense of dountful debts is not recognised in the year in which it is reallt occured, it will result in overstatement of net profit earned during the year. 2. Also, it will result in overstatement of Accounts Receivables at the end. Answer 2. If the amount previously written off as uncollectible are collected are recoded in two separate entries: 1. Reverse the write off by debiting Accounts receivables and crediting Allowance for Doubtful Accounts. The Journal Entry is: Accounts Receivables                                 Dr. Amount to be Collected / Receivable / Amt. Collected    To Allowance for Dountful Debts 2. Records the normal collection of account by debiting the Cash and crediting the Accounts Receivable. The Journal Entry is: Cash                                                                   Dr. Amt. Collected     To Accounts Receivables                            Answer 3. The basic approaches under the allowance method are: 1 .Percentage of Credit Sales—This estimate of uncollectible accounts is based on a historically determined percentage of each period’s credit sales. For example, if your company’s experience indicates that ultimate uncollectible accounts average about two percent of credit sales, an adjusting entry would be made at year-end that expensed two percent of the receivables with an offsetting credit to the reserve for bad-debt. 2. Percentage of Ending Accounts Receivable—Under this method the percentage of the ending balance of accounts receivable not expected to be collected is determined. The allowance account is then adjusted to equal this percentage. The method emphasizes valuation of the receivables at net realizable value on the balance sheet. 3. Aging of Accounts Receivable—This method is similar to Percentage of Ending Accounts Receivable, but it is a more precise variation. Aging considers that the longer a receivable is outstanding, the less likely it is to be collected. A separate estimate of the percentage of uncollectibles is applied to each age classification group instead of applying an overall percentage. The allowance method emphasizes reporting uncollectible accounts expense in the period in which the sales occur. This emphasis on matching expenses with related revenue is the preferred method of accounting for uncollectible receivables.

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