Question

As the accountant for Pure-Air Distributing, you attend a sales manager’s meeting devoted to a discussion of credit policies. At the meeting, you report that bad debts expense is estimated at be $ 59,000 and accounts receivable at year-end amount to 1,750,000 less a 43,000 allowance for doubtful accounts. Sid Omar, a sales manager, expresses confusion over why bad debts expense and allowance for doubtful accounts are different amounts. Write a one-page memorandum to him explaining why a difference in bad debts expense and the allowance for doubtful accounts is not unusual. The company estimates bad debts expanse as a 2% of sales.

Answer 1

The amount reported in Bad Debts Expense is the loss that occurred from extending credit during the period of time indicated in the heading of the income statement. Bad Debts Expense is usually an estimated amount based on a company's credit sales during the period or the change in the collectibility of its accounts receivable.

The amount reported in the Allowance for doubtful accounts is the estimated amount of the accounts receivable that will not be collected. The Allowance for Doubtful Accounts is a contra asset account or valuation account associated with the balance in Accounts Receivable. Since these two accounts are balance sheet accounts, their account balances must report the amounts that are relevant at a specific moment in time, namely the date of the balance sheet.

The allowance for doubtful accounts is a balance sheet account that reduces the reported amount of accounts receivable. (A change to the balance in the allowance for doubtful accounts also affects bad debt expense on the income statement.) Providing an allowance for doubtful accounts presents a more realistic picture of how much of the accounts receivable will be turning to cash. After all, a company selling products (or services) on credit to thousands of customers will likely have a few customers who will not be able to pay the full amount they owe to the company.

By recording an amount in the allowance for doubtful accounts it will also mean that the bad debt expense will be reported closer to the time of the sales—instead of waiting until the account is determined to be uncollectible. Hence, the matching principle is carried out more effectively.

The allowance account and the related bad debt expense is encouraged for financial reporting; however, it is not acceptable for income tax reporting. The Internal Revenue Service prefers that any expense for bad debts be deducted later—when an account is actually written off as uncollectible.

To illustrate, let's assume that on December 31 a company had $100,000 in Accounts Receivable and its balance in Allowance for Doubtful Accounts was a credit balance of $3,000. For the first 30 days of January the company does not have any other information on bad accounts. Then on January 31 the company learns that an additional $1,000 of its accounts receivable will not be collectible. On January 31 the company will make an adjusting entry to debit Bad Debts Expense for $1,000 and to credit Allowance for Doubtful Accounts for $1,000. After this entry is recorded, the company's income statement for the month of January will report Bad Debts Expense of $1,000 and its January 31 balance sheet will report a credit balance in Allowance for Doubtful Accounts in the amount of $4,000.