Question

As the accountant for Pure-Air Distributing, you attend a sales managers’ meeting devoted to a discussion of credit policies. At the meeting, you report that bad debts expense is estimated to 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 the 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 expense as 2% of sales.

Short answer

Answer

The difference exists between the balance of the allowance account and the bad debt expense account because the allowance account includes estimates of bad debts and bad debt expenses include the actual bad debts of the business entity that are compensated through the allowance account.

Step-by-step solution

Step-By-Step SolutionStep 1: Definition of Bad Debts

The amount that will not collect from the receivables is considered a bad debt of the business entity. These bad debts are considered expenses of the business entity.

Memorandum

To: Sales Manager

From: Accountant

Subject: Difference in allowance for bad debt and bad debt expenses

When the business entity makes credit sales, an allowance account is created for bad debts. Two accounting methods are adopted for reporting bad debts:

1. Allowance method.

2. Direct write-off method.

In the above situation, the balance in bad debt is $59,000, and the balance in the allowance for bad debt is $43,000. Such differences exist because the business entity first creates the allowance for bad debts by crediting them. The amount for such an account is calculated based on the estimated percentage of accounts receivables. This account is debited when the business entity determines actual bad debt expenses for the year. Debiting allowance will reduce the balance in the allowance account.