Appearing next is information pertaining to Garrels Company’s Allowance for credit losses. Examine this information and answer the following questions.

Required:

1. Solve for the unknowns in the preceding schedule. (Hint: Use T-accounts.)

2. Make all entries related to the Allowance for credit losses account for 20X0–20X2.

3. Make all entries for bad debts for 20X0–20X2 assuming that Garrels did not accrue for estimated bad debt losses but instead recorded its bad debt provisions once receivables were determined to be uncollectible. (This is called the direct write-off method.)

4. Why does GAAP require the allowance method over the direct write-off method?

5. Calculate the cumulative difference in reported pre-tax income under the allowance and direct write-off methods over the 20X0–20X2 period.

6. Assume that it is the end of 20X3 and Garrels management is trying to decide on the amount of the bad debt provision for 20X3. Based on an aging of accounts receivable, the accounting department believes that a $400,000 provision is appropriate. However, the company just learned that a customer with an outstanding accounts receivable of $300,000 may have to file for bankruptcy. The decision facing Garrels management is whether to increase the initial provision of $400,000 by $300,000, by some lesser amount, or by nothing at all. What is your recommendation?

7. Continuing the scenario from requirement 6, now consider the following additional information. Assume that you are a member of the company’s compensation committee. Assume further that the company’s chief financial officer (CFO) is solely responsible for deciding the amount of the credit loss expense to record and that the CFO has a cash bonus plan that is a function of reported earnings before income taxes. Specifically, assume that the CFO receives an annual cash bonus of zero if earnings before income taxes are below $17 million and 10.0% of the amount by which earnings before income taxes exceed $17 million and up to a maximum bonus of $1 million (that is, when net income reaches $27 million, no further bonus is earned). What adjustment to the initial $400,000 credit loss expense might the CFO make in each of the following scenarios? Assume that the following earnings before income taxes include the initial $400,000 provision for bad debts.

a. $11 million

b. $18.2 million

c. $38.25 million

d. $27.15 million

8. What other scenarios can you identify in which managers might use the provision for bad debts to accomplish some contract-related strategy?

9. Identify other items in the financial statements (besides the bad debt provision) that managers have the ability to “manage.”

Transcribed Image Text:

Years Ended October 31, ($ in thousands) 20X2 20X1 20X0 Allowance for credit losses $1,324 1,349 Balance, beginning of year Provision charged to expense Write-offs, less recoveries Balance, end of year ? ? 502 1 622 ? 1,453 ? 1,302