Subject: Bad Debt Expense Memo Introduction Your company has three uncollectible accounts which from three new customers: University of Hare-Brain, Dim-State University, and the College of Silly, each of them owned amount of $5,000 when they filed for bankruptcy. You decide whether to write the total $15,000 account payable off as a bad debt expense and report an operating loss, or just report these losses as extraordinary event and this method allow you to report $7,500 operating profit instead of report operating loss.
Because you have to present your first year operating statement to a multi-national search company in order to sell your SEC filling search business, the decision you made will be really important for you under this circumstance. So the purpose for me to write this memo is to help my client, Dr Kealey to classify the uncollectable accounts and how to report these losses on the financial statement. Solution Based on my investigation, I will support Dr. Kealey to report these losses as bad debt expense instead of extraordinary losses on the financial statement.
Because extraordinary loss is an unusual or infrequency loss resulting from an exceptional cause- which is the “natural” transaction of the account and it will not be collectable in the future. According to the FASB codification-225-20-45, extraordinary events or transaction are not reasonably expected to recur in the foreseeable future in considered to occur infrequently. So the losses from the default by the customers are not qualified as the extraordinary item. Also presenting the losses as the extraordinary event will represent the unfaithful attitude to the external users.
Because it is natural for the company who has the bad debt expense during the operation, it’s unnecessary to hide any losses in order to demonstrate the success of the operating for the company. Also, a complete and accurate statement can help managers to formulate the way forward for the future decision. So write this uncollectible loss as extraordinary event is an unintelligent decision. Companies have to follow the GAAP principle when prepare and standardize the reporting of financial statements.
Without GAAP, companies would be free to decide what financial information to report and how to report it on the statement. Doing this will making the operation record quite difficult for users who have relationship with the company to understand the state of operating. Because financial statements prepared under GAAP are intended to reflect an economic reality, GAAP makes a company’s financials comparable and understandable so the users can make rational investment or other financial decisions. Company also needs the conceptual framework to make the financials useful when making decision.
A conceptual framework underlying financial accounting is important because it can lead to consistent standards and it prescribes the nature, function, and limits of financial accounting and financial statement. It makes the information which reported on the financial statement are both relevant and representationally faithful. Relevant means the information must have predictive value- the value can help the investors to form their own expectation about the future, confirmatory value- helps users confirm or correct prior expectations and materiality- a company-specific aspect of relevance.
Report these losses as a bad debt expense will help the users to analysis the previous operation performance for your company. Investors will make the expectation about the future based on the previous financials. But if you just write these losses off as extraordinary losses, investors will have no idea how to evaluation the pervious performance, because it will shows the losses is come from nature and it’s totally out of control. It is difficult for to evaluate your company because the information you report is uncertainty.
Faithful representation require the information has to be completeness- means all the information is necessary to provide; neutrality- means company cannot select which information they like or interest and free from error- means the information will be a more accurate of a financial item. According to the fundamental qualities of the conceptual framework, the financial statement must be completed with all information and keep these information free from bias.
Investors use the financial disclosures to evaluating a company’s growth prospects, the riskiness and the long-term success of the company’s business model. Under the current situation, Dr. Kealey cannot choose how to write these losses off as what he favors. Even bad debt expense will lead to the operating income negative, companies still have the responsibility to keep the information they represented is neutrality to the users. Conclusion Report the $15,000 uncollectible account as bed debts expenses will be the best choice by follow the making-rule through GAAP.
And based on the conceptual framework, bad debt expense is also more qualified than the extraordinary loss for the financial statement. If you company doesn’t follow the GAAP principle and report these account randomly as what you prefer in order to make the profit at the financial statement. The information will mislead the company’s future decision and also it will be lead to the failure of selling. So, as to what I explain above, I will support Dr. Kealey report the $15,000 defaulted account as bad debt expenses on financial statement instead of extraordinary loss.
References “The Critical Nature of Neutral Financial Reporting” By Rebecca Todd McEnally, CFA, and Patricia Doran Walters, CFA, Article from FASB Report, August 29, 2003 http://www. fasb. org/cs/BlobServer? blobkey=id;amp;blobwhere=1175818765436;amp;blobheader=application%2Fpdf;amp;blobcol=urldata;amp;blobtable=MungoBlobs “General Accepted Accounting Principles or GAAP: What does it mean? ” By Stephanie Paul – Sep 2008. Web http://www. legalzoom. com/business-management/running-your-business/general-accepted-accounting-principles-or