Chapter 5, Problem 5.5BP

Compare the direct write-off method to the allowance method (LO5–3, 5–6)

Letni Corporation engages in the manufacture and sale of semiconductor chips for the computing and communications industries. During the past year, operating revenues remained relatively flat compared to the prior year but management notices a big increase in accounts receivable. The increase in receivables is largely due to the recent economic slowdown in the computing and telecommunications industries. Many of the company’s customers are having financial difficulty, lengthening the period of time it takes to collect on accounts. Below are year-end amounts.

Age Group	Operating Revenue	Accounts Receivable	Average Age	Accounts Written Off
Two years ago	$1,300,000	$150,000	5 days	$ 0
Last year	1,600,000	160,000	7 days	1,000
Current year	1,700,000	330,000	40 days	0

Paul the CEO of Letni, notices that accounts written off over the past three years have been minimal and, therefore, suggests that no allowance for uncollectible accounts be established in the current year. Any account proving uncollectible can be charged to next year’s financial statements (the direct write-off method).

Required:

1.    Do you agree with Paul’s reasoning? Explain.

  2.    Suppose that other companies in these industries have had similar increasing trends in accounts receivable aging. These companies also had very successful collections in the past but now estimate uncollectible accounts to be 25% because of the significant downturn in the industries. If Letni uses the allowance method estimated at 25% of accounts receivable, what should be the balance of Allowance for Uncollectible Accounts at the end of the current year?

  3.    Based on your answer in Requirement 2, for what amount will total assets and expenses be misstated in the current year if Letni uses the direct write-off method? Ignore tax effects.