What if a company's Allowance for Doubtful Accounts is understated?

Definition of Allowance for Doubtful Accounts

The Allowance for Doubtful Accounts is a contra asset account. The Allowance account's credit balance is presented with or combined with the debit balance in the Accounts Receivable so that the balance sheet reports the net amount that is expected to be collected.

The credit balance in the Allowance account is associated with the income statement account Bad Debts Expense. In other words, when a company anticipates not collecting all of its accounts receivable, it should prepare an adjusting entry that debits Bad Debts Expense and credits Allowance for Doubtful Accounts.

If a company does not make a needed credit entry to the Allowance account, the company's income statement will report too much net income and the balance sheet will be overstating the amount of the accounts receivable that will be collected.

Example of Allowance for Doubtful Accounts

Assume a company has $230,000 of accounts receivable at the end of its accounting year. Its Allowance for Doubtful Accounts (before any further adjustment) has a credit balance of $10,000. At this point, the company's balance sheet will report that the company will collect the net amount of $220,000. However, the credit manager's recent review indicates that the company will not be collecting a total of $25,000 of the accounts receivable.

Based on the new information, the accountant should write an adjusting entry that debits Bad Debts Expense for $15,000 and credits Allowance for Doubtful Accounts for $15,000. After this adjusting entry is made: 1) the balance sheet will report the correct net amount of $205,000 ($230,000 - $25,000) not the overstated, incorrect amount of $220,000, and 2) the income statement will report the correct amount of net income, which is $15,000 less than the original, incorrect amount of net income.

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