Q1
The Chief Executive officer is wrong about the impact of raising the provision for bad debts. The following calculation highlights the logic behind the increase in the provision for bad debts:
Supposing the company makes annual sales of $1000000 and makes the traditional allowance for doubtful debts of 1.5 per cent of the total sales.
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Then, in the first year, based on the principles of accounting for bad debts, the following entries are made in the income statement and the balance sheet:
Debit: The allowance for doubtful debts in the income statement by $15000 (1.5% of $1000000)
Credit: the allowance for doubtful debts in the balance sheet by $15000 (a reverse account that used to offset the account receivables)
However, if the firm decides to raise the allowance for doubtful debts from 1.5 per cent to 3 per cent in the second trading year, the adjusted figures will double as indicated below:
Debit: The allowance for doubtful debts in the income statement by $30000 (3% of $1000000)
Credit: the allowance for doubtful debts in the balance sheet by $30000 (a reverse account that used to offset the account receivables)
Considering the impacts of the two adjustments reveals the following:
From the income statement:
During the first trading period, the profits of the company were lowered by $15000 from say $500000 to $485000 and by $30000 to $470000 in the second period.
From the balance sheet:
The trade debtors of the company were reduced by $15000 from $1000000 to $985000 in the first year and by $30000 to $970000 in the second year.
Based on the dual concept as outlined, an increase in the allowance for bad debts has the effect of reducing the profits of the company and the value of the trade debtor asset. The CEO should further be warned about likely penalties of raising the allowance for bad debts that auditors are likely to give to the firm when it comes to tax remittance.
Q2
Yes, there is a need to recalculate the allowance for doubtful debts. The reason for this conclusion is the fact that the allowance for doubtful debts for the company is credited in the balance sheet because it reduces the value of debtor asset. In addition the profitability of a company cannot be determined by the balance sheet to which the provision for doubtful is credited. It means that while a rise in the percentage of provision for doubtful debts reduces the assets on the balance sheet, it is treated as an operating expense in the income statement, which is used to determine the profitability of trading operations because it is debited. Principally, expenses reduce the net profits of the companies. Therefore, if the telecommunications company decides to raise the percentage of the adjustment, the outcome will be raising the operating expenses and reducing the profits. In addition, the company is likely to attract keen and penal auditing if it exaggerates its provision for doubtful debts and ends up incurring a lower percentage of bad debts than the estimation.
Q3
Instead of fixing the percentage of the provision for doubtful debts, the company should undertake thoughtful estimations. First, the firm should determine the first time allowance, which is calculated considering that the current allowance for doubtful debts needs to be equal to the end accounts receivables balance percentage for the bad debts. In this case, the company should use its history of bad debts to determine the percentage it assigns the allowance for bad debts because it is a more accurate approximation than fixing without considering other factors. In addition, the firm should explore alternatives to raise its profitability without adjusting the percentage of allowance for doubtful debts. For example, it is reported that the company has not been able to compete favorably because it uses relatively low levels of technology. Therefore, tackling the technological setbacks could be a viable approach to raising the profitability of the firm.
