Question

What does allowance for doubtful accounts represent and where is located in the financial statements? If management understates the estimate for bad debt expense what impact will it have on the financial statements?

Answer 1

What does allowance for doubtful accounts represent and where is located in the financial statements?

The allowance for doubtful accounts is a reduction of the total amount of accounts receivable appearing on a company’s balance sheet, and is listed as a deduction immediately below the accounts receivable line item.

The allowance represents management’s best estimate of the amount of accounts receivable that will not be paid by customers. It does not necessarily reflect subsequent actual experience, which could differ markedly from expectations.

The allowance for doubtful accounts is a contra-asset account that records the amount of receivables expected to be uncollectible.

If management understates the estimate for bad debt expense what impact will it have on the financial statements?

Overstated Carrying Value

Overstating accounts receivable directly inflates the size of a company’s balance sheet. Following GAAP, companies report assets at their original cost but re-evaluate and make adjustments over time based on an asset’s changing fair market value. Accounts receivable are reported as a current asset in the balance sheet, and overstating accounts receivable results in unadjusted and thus inflated carrying value of the initially reported accounts receivable. Under GAAP, the carrying value, or fair market value, of outstanding accounts receivable is the amount of originally recorded accounts receivable subtracted by the amount of uncollectible, or doubtful accounts

Understated Bad Debts

Any uncollectible accounts receivable are unpaid debt by customers and constitute a bad debt expense for the company. As a result of not taking into account uncollectible customer accounts, overstating accounts receivable understates a company’s bad debt expense. Such bad debt expenses would have been reported in a company’s income statement as a deduction from revenue. Thus, overstating accounts receivable indirectly overstates a company’s reported net income. When net income is closed to retained earnings at the end of an accounting period, retained earnings as an equity in the balance sheet is also overstated.

Cash flow is unaffected

Companies sometimes refer to accounts receivable for cash flow calculation. For example, when calculating cash flows based on net income, companies need to subtract any increase in accounts receivable from net income because accounts receivable as sales included in net income are not cash. It seems then that used as a subtraction from net income, overstated accounts receivable may further reduce cash flow. However, because the same overstated accounts receivable has been also included in the net income calculation, the net effect of overstating accounts receivable on cash flow is actually zero.

As bad debts expense goes up, net income goes down. Therefore, if bad debts expense is underestimated (too low), net income will be overstated (too high) for the year.

If bad debts is understated, the "AFDA" account balance will be left understated as well. This will result in total assets being overstated.

Net income flows into retained earnings on the balance sheet. Therefore, if net income is overstated, the retained earnings balance will be left overstated. Retained earnings is a component of total stockholders' equity.