A general contractor discovers that a major client who owes $75,000 has filed for bankruptcy. How should this be handled in the company's accounting records?
Correct Answer
A) Write off the entire amount as bad debt expense
When a customer files for bankruptcy and collection is unlikely, the receivable should be written off as bad debt expense. This follows the conservatism principle and provides accurate financial reporting.
Why This Is the Correct Answer
When a customer files for bankruptcy, collection of the debt becomes highly unlikely or impossible. Under Generally Accepted Accounting Principles (GAAP), the conservatism principle requires businesses to recognize losses when they become probable. Writing off the receivable as bad debt expense immediately reflects the economic reality of the situation and prevents the financial statements from overstating assets and income. This provides stakeholders with accurate, conservative financial information.
Why the Other Options Are Wrong
Option C: Transfer the amount to long-term receivables
Transferring to long-term receivables merely reclassifies the debt without addressing the fundamental issue that collection is unlikely due to bankruptcy. This approach fails to recognize the probable loss and continues to overstate assets on the balance sheet.
Option D: Reduce the receivable by 50% and wait for bankruptcy proceedings
Arbitrarily reducing the receivable by 50% without basis is not proper accounting practice. While bankruptcy proceedings might eventually recover some funds, the conservative approach requires writing off the full amount when collection becomes doubtful, with any future recoveries recorded separately when received.
Memory Technique
Use the mnemonic 'BBC' - Bankruptcy = Bad debt = Conservative accounting. When a customer goes bankrupt, be conservative and write it off completely.
Reference Hint
Look up 'Bad Debt Expense' and 'Accounts Receivable Write-offs' in the accounting/financial management chapter of your contractor reference manual
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