Chapter 5, Problem 5.7BP

Underestimating future uncollectible accounts (LO5–3, 5–5)

By the end of its first year of operations, Previts Corporation has credit sales of $750,000 and accounts receivable of $350,000. Given it’s the first year of operations. Previts’ management is unsure how much allowance for uncollectible accounts it should establish. One of the company’s competitors, which has been in the same industry for an extended period, estimates uncollectible accounts to be 2% of ending accounts receivable, so Previts decides to use that same amount. However, actual write-offs in the following year were 25% of the $350,000 (= $87,500). Previts’ inexperience in the industry led to making sales to high credit risk customers.

Required:

  1.    Record the adjustment for uncollectible accounts at the end of the first war of operations using the 2% estimate of accounts receivable.

  2.    By the end of the second war, Previts has the benefit of hindsight to know that estimates of uncollectible accounts in the first year were too low. By how much did Previts underestimate uncollectible accounts in the first year? How did this underestimation affect the reported amounts of total assets and expenses at the end of the first war? Ignore tax effects.

  3.    Should Previts prepare new financial statements for the first year of operations to show the correct amount of uncollectible accounts? Explain.