Question

You are preparing the December 31, Year 2, financial statements. Required a. Your analysis of accounts receivable indicates the following for Year 2: Accounts receivable – January $ 175,000 Allowance for doubtful accounts – January 1 17,500 Credit sales during the year 600,000 Cash collections during the year 575,000 Your analysis of the aged accounts receivable at the year indicates: 1. A key customer, Alpha, went bankrupt during the year, and there will be no further collections on this account receivable of $10,000. 2. After accounting for the Alpha receivable, an aging of the remaining accounts receivable at the end of the year indicated that an allowance for doubtful accounts of $32,500 is required as of December 31, Year 2 for other customers. Prepare the Year 2 journal entries required to (i) write-off the Alpha account receivable and to (ii) record bad debts expense (include your calculation). b. Your analysis of inventory indicates that Year 1 ending inventory was understated by $30,000 due to a counting error. Inventory at the end of Year 2 was correctly calculated.

Indicate the effect of the error (if any) on each of the following, indicating whether overstated, understated, or not affected and provide the amount. i) Year 1 net income ii) Year 1 cost of goods sold iii) December 31, Year 2 retained earnings

Answer 1

A. Journal entries

i. Write off alpha account

Bad debt account Dr. $10000

To alpha account $10000

( Being unrecoverable amount recorded)

ii. Record bad debt in profit and loss account

Bad debt. $10000

Add new provision at

the end of the year. $32500

Less. Old provision. At

The beginning. ($117500)

Net amount. ( 75000)

There is excess provision which need to be reversed during the year by crediting it to profit and loss account.

Provision/allowance for bad debt a/c Dr 75000

To profit and loss account $ 75000

B effect of understated closing inventory by $30000

i. Year 1 net income-

If closing inventory is understated then the net income is also understated by the same amount.

ii. If closing inventory is understated, it shows an overstated cost of good sold

Cost of goods sold = opening stock +purchases+ direct cost of manufacture- closing stock

This increase in cost of goods sold has resulted in understatement of net income.

iii. Dec 31 yr 2 retained earnings

In the year 2 opening stock is the amount which is brought forward from the last year's closing stock, hence it is understated by $ 30000

If opening stock is understated this results in reduced cost of goods sold which ultimately results in overstated net income.

Hence the retained earnings will be over stated by $ 30000 in year 2