EXERCISE 4–1 On December 31, Year 1, Carme Company reports its accounts receivable from credit sales to customers. Carme Company uses the allowance method, based on credit sales, to estimate bad debts. Based on past experience, Carme fails to collect about 1% of its credit sales. Carme expects this pattern to continue.

Required:

a. Discuss the rationale for using an allowance method based on credit sales to estimate bad debts. Contrast this method with an allowance method based on the accounts receivable balance.

b. How should Carme report its allowance for bad debts account on its balance sheet at December 31, Year 1?

Describe the alternatives, if any, for presentation of bad debt expense in Carme’s Year 1 income statement.

c. Explain the analysis objectives when evaluating the reasonableness of Carme’s allowance for bad debts.