Question

Explain the importance of completing the reporting procedures and required documentation for bad and doubtful debts

Answer 1

The importance of completing the reporting procedures and required documentation for bad and doubtful debts:

An Association may not always be able to collect the assessments receivable balances owed by its members. If it is anticipated that a receivable most likely will not be collected, an allowance for doubtful accounts may be established and a bad debt expense is recorded. Bad debts typically arise as a result of a unit owner being unable to fulfill their obligation to pay an outstanding receivable balance due to the organization.

It is recommended that bad debt expense should be recorded throughout the year to follow the accrual basis of accounting. Meaning, revenue should be recognized as billed and expenses should be recognized as incurred. When the customers are billed an entry is recorded to debit (increase) accounts receivable and credit (increase) maintenance assessments. When the customers remit payment, a new entry is recorded to debit (increase) cash and credit (decrease) accounts receivable. These two entries reflect the ideal situation and would not require an entry for bad debt expense. A problem arises when customers do not remit payment and the receivable balance grows and becomes delinquent. If the Organization does not anticipate receiving payment from the customer, a corresponding entry to debit (increase) bad debt expense and credit (increase) the allowance for doubtful accounts should be recorded to recognize the related bad debt expense when the income is recorded.

Bad debt expense is a line item that most Organization should be include in their annual budget. The cost of customers not paying their due balances can cause a few common problems: ) a short term operating fund deficit, 2) future problems with the Organizations' ability to adequately fund the replacement fund, and 3) the Board may be forced to pass a special assessment to raise additional funds. These unfavorable situations can be mitigated by appropriately planning and budgeting for bad debt expense. Budgeting for bad debt expense will increase maintenance assessments on the onset but will reduce the probability that the Organization will have to make up lost revenues through a special assessment in the future, or face the other unfavorable situations discussed above. Unfortunately, the nonpaying customers are a burden that the balance of timely paying unit owners will be required to “make up.”

When the Board receives the financial statements it is important to understand how the balance sheet line item shown “Accounts Receivable, net of allowance for doubtful accounts” should be interpreted. The allowance for doubtful accounts reduces the amount of accounts receivable on the balance sheet, as it is shown as net. The net amount of accounts receivable shows the amount the Organization estimates to be collectible. Without the allowance for doubtful accounts if necessary, the Organization’s balance sheet would be overstating assets as it would be deeming 100% of the receivable collectible. For example, if the Organization has accounts receivable of $100,000 and an allowance for doubtful accounts of $80,000 the net accounts receivable shown on the balance sheet would be $20,000. This means that that $20,000 is estimated to be collectible and $80,000 is estimated to be unlikely to collect.

In addition, the allowance for doubtful accounts is a cumulative total that reflects current year and prior years’ activity. The current year impact is shown in the financial statements through the line items on the back pages and cash flow statement titled “bad debt expense”, “bad debt recovery”, or “reduction in allowance for doubtful accounts”. These line items reflect the current year increase (decrease) in the allowance for doubtful accounts.

The Board and management should work together throughout the year to ensure that internally generated financial statements accurately reflect the Organizations’ current financial position. By budgeting and recording bad debt expense – the most significant non-cash expense – throughout the year, the likelihood of an unpleasant Board surprise when the audited financial statements are issued is mitigated. It is important to remember that bad debt expense is a moving target and should be evaluated on a recurring basis. Any decisions regarding the collectability of accounts receivable should be discussed with the management. The Organizations'’ CPA can assist the Board and management in determining policies and procedures to appropriately allow for doubtful accounts throughout the year.