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Memorandum

To: Controller
From: Hans Christian Imperial
Re: Percentage of accounts receivable balance vs. percentage-of-sales

Background
The credit policy of Gabitan, Inc. has been changed several months ago. Since then,
there has been a dramatic increase in the number of accounts receivable that are past due.
The company calculates the allowance for doubtful accounts based on the percentage of
the ending receivables balance and you think that it is more appropriate to use a
percentage-of-sales method to calculate the allowance for doubtful accounts.

Purpose
The objective of this memorandum is to analyze the effect of the change in the
credit policy of the firm and the existing method in calculating the allowance for doubtful
accounts, and to give recommendation whether to change the method in calculating the
allowance of doubtful accounts to present a more accurate and appropriate figure in the
allowance for doubtful accounts.

Conclusion and Recommendation


The percentage of ending receivables balance is accounted for using the balance
sheet of the company, although this is better at estimating the true net realizable value of
the accounts receivable, it is less precise in meeting the requirement of the matching
principle. A problem with computing allowance for doubtful accounts based on percentage
of ending balance is that it may not be sufficiently refined, it does not account for the
different ages of the accounts receivable, only the grand total of all receivables.
The percentage-of-sales on the other hand is accounted for using the income
statement of the company, it assumes that a percentage of the sales of the company are
uncollectible, thus it more accurately complies with the requirement of the matching
principle which means that you should record the expense in the income statement in the
same period by matching it with the corresponding revenue.
Since the credit terms of the company were modified a few months ago in hopes to
increase sales and this resulted in a dramatic increase in accounts receivable past due, the
company should stop using the percentage of ending accounts receivable balance to
compute for the allowance because the ending accounts receivable would be very large
due to all the past due accounts receivable resulting to a huge amount of allowance for
doubtful accounts. This computed allowance will also not take into consideration the age
of accounts receivable. The company should perform an analysis of historical data and
determine what percentage of accounts receivable at a point in the past subsequently
became uncollectible. But since the credit terms of the company were changed, this method
would be much harder to do. I would recommend the usage of percentage-of-sales to
compute for the allowance for doubtful accounts. This method will show that no matter
how much sales the company will produce, it assumes that a percentage in that sales of the
company are uncollectible and therefore, already accounted for.

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