A contractor discovers that a major customer who owes $75,000 has filed for bankruptcy and will likely pay only 20 cents on the dollar. How should this be handled in the accounting records?
Correct Answer
A) Reduce accounts receivable by $60,000 and recognize bad debt expense
The contractor should write off the estimated uncollectible portion ($75,000 × 80% = $60,000) as bad debt expense, leaving $15,000 as the expected recovery amount in accounts receivable.
Why This Is the Correct Answer
Option C correctly applies the accounting principle of recognizing bad debt when it becomes probable that collection will not occur in full. When a customer files bankruptcy and is expected to pay only 20 cents on the dollar, the contractor should immediately write off the estimated uncollectible portion ($60,000) as bad debt expense. This leaves the realistic expected recovery amount ($15,000) in accounts receivable, providing an accurate financial picture.
Why the Other Options Are Wrong
Option B: Transfer the amount to long-term receivables
Writing off the entire $75,000 would be incorrect because the customer is expected to pay 20 cents on the dollar ($15,000). This would overstate the loss and understate assets.
Option D: Wait until bankruptcy proceedings are complete
Waiting until bankruptcy proceedings are complete violates the matching principle and conservatism principle in accounting. Financial statements should reflect known losses when they become probable, not when they are finalized.
Memory Technique
Use 'WRAP' - Write off what you Won't Recover, And Preserve what's probable (20 cents = 20% recovery)
Reference Hint
Business and Finance chapter covering accounts receivable, bad debt expense, and financial statement preparation
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