To: Chief Executive Officer
From: Independent auditor
27th October 2014
Subject: Understatement of bad debts
Upon review of the information that relates to accounts receivable, I have noticed that the write-offs have been surpassing the reserves that have been made at year-end. The documents show that as the balances of bad debt rose, the entity did not follow the policies that guide write-offs. This indicates a situation of understatement of the value of bad debt and it has an effect of inflating income.
Various transactions were picked and the correct accounting treatment of these transactions is discussed. For instance, the company will post $5000 on the credit side of the sales account and a similar amount on the debit side of the debtors account when a sale worth $5000 is made on credit. Post $350 on the credit side of the debtor’s account and an equal amount on the credit side of the cash account for the first payment received by the company.
If the customer fails to make a monthly payment for June, in July, the payment will be due by more than 30 days. Therefore, it will fall in the first category of the ageing schedule. The entity should calculate the value of allowance for the doubtful debt at the rate of 5% of the amount that is due. This will amount to $17.5 (5% * $350). In the event that the customer makes a payment of $250 in July, this will be more than the two-thirds threshold stated in the policy.
Therefore, the account will be moved back and there will be no allowance calculated. According to the policy, Friedman’s should provide for the allowance of doubtful debt for payments that are due between June and September. However, in October, the debt should be written off because it will be due by more than 120 days. If the customer makes a payment worth $250 in November, then this will be treated as a bad debt recovered because the whole amount had been written off. The accounting entries required in this scenario involve reinstating the accounts receivable account and then passing an entry to record the cash received.
First, the company started practising scooping. This represents a scenario where the staff involved decided to increase the length of the write-off period without following the laid down procedures. Extending the period allows the company to collect additional payments. This practice is intended to achieve a certain level of income. The second accounting practice was reducing the minimum percentage of payment of what makes up curing payment.
This has the potential of averting an account from being categorized under write-off. This reduces the number of accounts under write-off. The final possible practice is changing the age of doubtful accounts. For instance, if an account is 120 days overdue, then the company reduces the age of the debt to 60 days. This practice had the potential of increasing the length of the period before the accounts are written off. The actions have a material impact on the financial reports presented by the company. The audit revealed that the actual write-off exceeded the reserve that was made at year-end. Therefore, the company needs to adjust the value affected so that the financial statements do not mislead the users.