Chapter 8, Problem 8.4SDC

Ethical Decision Making: A Real-Life Example

You work for a company named MCI and you have been assigned the job of adjusting the company’s Allowance for Doubtful Accounts balance. You obtained the following aged listing of customer account balances for December.

Historically, bad debt loss rates for each aging category have been 1% (0–30 days). 5% (31–60 days), 8% (61–90 days), 10% (91–120 days), and 50% (> 120 days). Using these rates, you calculate a desired balance for the allowance. No entries have been made to the account since the end of November, when the account had a credit balance of $46,820.

To check the reasonableness of the calculated balance, you obtain the aged listings for prior months (shown below). As you scan the listings, you notice an interesting pattern. Several account balances, which had grown quite large by the end of November, had disappeared in the final month of the year. You ask the accounts receivable manager, Walter Pavlo, what happened. He said the customers “obtained some financing ... I guess out of nowhere” and they must have used it to pay off their account balances.

Required:

1. 1. Calculate the balance that should be reported in Allowance for Doubtful Accounts as of December 31.
2. 2. Prepare the adjusting journal entry that is required on December 31.
3. 3. Show how Accounts Receivable would be reported on the balance sheet at December 31.
4. 4. If the balances for CT&T, NewTel, and Telemedia at the end of November continued to exist at the end of December (in the over-120-days category), what balance would you have estimated for the Allowance for Doubtful Accounts on December 31? Would this have changed MCI’s net income in the current year? Explain.
5. 5. A few days later, you overhear Mr. Pavlo talking about the account receivable from Hi-Rim. Apparently, MCI will soon loan Hi-Rim some money, creating a note receivable. Hi-Rim will use the money to pay off the Accounts Receivable balance it owes to MCI. You are aware that Mr. Pavlo receives a bonus based on MCI’s net income. Should you investigate this matter farther? Explain why or why not.

Epilogue: The events described above are based on an article in the June 10, 2002, issue of Forbes magazine that describes how Walter Pavlo was pressured to commit accounting fraud at MCI. Ironically, MCI was later taken over by WorldCom—the company that went on to commit the world’s largest accounting fraud at the time.