A contractor discovers that a major customer owing $45,000 has filed for bankruptcy and will likely pay nothing. How should this be handled in the accounting records?
Correct Answer
B) Write off the receivable as bad debt expense
When a receivable becomes uncollectible, it should be written off by debiting bad debt expense and crediting accounts receivable. This removes the uncollectible amount from assets and recognizes the loss.
Why This Is the Correct Answer
When a receivable becomes uncollectible due to bankruptcy, proper accounting principles require immediate recognition of the loss through a bad debt expense entry. This involves debiting bad debt expense (increasing expenses) and crediting accounts receivable (decreasing assets) to remove the uncollectible amount from the books. This follows the matching principle by recognizing the expense in the period when the loss is determined, and accurately reflects the company's true financial position by removing an asset that has no value.
Why the Other Options Are Wrong
Option C: Transfer the amount to accounts payable
Recording as prepaid expense would incorrectly classify this as an asset representing future benefits, when in reality the amount is a loss with no future value or benefit to the company.
Option D: Record it as a prepaid expense
Waiting until bankruptcy proceedings are complete violates the matching principle and overstates assets on the balance sheet, as the receivable has already been determined to be uncollectible when the customer filed for bankruptcy.
Memory Technique
Think 'BBC' - Bankrupt customers become Bad debt, Credit the receivable (remove the asset) and Debit bad debt expense (recognize the loss).
Reference Hint
Look up 'Accounts Receivable and Bad Debt' in the accounting/bookkeeping chapter of your contractor reference manual, typically found in the business management section.
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