Management uses the percentage-of-sales approach method to calculate the allowance for doubtful debts.Management calculated the allowance for doubtful debts on the basis of 2 per cent of sales.However,by year-end it was aware that the rate should have really been 3 per cent of sales.Management does not adjust the allowance for doubtful debts at year-end.As a result:
A) assets are overstated,and net profit is overstated.
B) assets are overstated,and net profit is understated.
C) assets are understated,and net profit is overstated.
D) assets are understated,and net profit is understated.

Question

Quizplus · Accepted Answer

The allowance for doubtful debts is a contra-asset account that reduces the value of accounts receivable to their estimated net realizable value. If management underestimated the required allowance for doubtful debts, it means that accounts receivable are overstated and therefore assets are overstated as well.

Moreover, if management did not adjust the allowance for doubtful debts at year-end to reflect the higher rate of uncollectible accounts, it means that net profit is also overstated because bad debt expense is understated. Bad debt expense is an expense that reflects the cost of estimated uncollectible accounts, and it reduces net income. Therefore, if bad debt expense is lower than it should be, net income is higher than it should be.

Management Uses the Percentage-Of-Sales Approach Method to Calculate the Allowance