Question

Hughes Company has a credit balance of \(\$ 5,000\) in its Allowance for Doubtful Accounts before any adjustments are made at the end of the year. Based on review and aging of its accounts receivable at the end of the year, Hughes estimates that \(60,000 of its receivables are uncol- lectible. The amount of bad debts expense which should be reported for the year is: a. \)5,000. c. \(60,000. b. \)55,000. d. $65,000.

Short answer

The bad debts expense to report is $55,000 (Option b).

Step-by-step solution

Identify Initial Allowance

Hughes Company begins with a credit balance of $5,000 in its Allowance for Doubtful Accounts as of the start of the account adjustments.

Determine Estimated Uncollectibles

After reviewing and aging its accounts receivable, Hughes estimates that $60,000 of its receivables are uncollectible by the end of the accounting period.

Calculate Required Adjustment

The adjustment required to match the estimated uncollectible accounts (\(60,000) with the existing allowance credit balance (\)5,000) is calculated by subtracting the credit balance from the estimate: \[ 60,000 - 5,000 = 55,000 \]

Identify Bad Debts Expense

The amount calculated in Step 3, $55,000, is the bad debts expense Hughes needs to report for the year to adjust the allowance to the estimated uncollectibles.

Key concepts

Bad Debts Expense

In the world of accounting, **bad debts expense** is a term that refers to the estimated amount of accounts receivable that a business does not expect to collect. Essentially, it's an acknowledgment that not all customers will pay what they owe. Bad debts expense is typically recorded as an expense on the income statement, reducing the net income for the period in which it is recorded.

Companies estimate bad debts expense because it's impractical to determine precisely which accounts will go unpaid in the future. By recognizing this expense sooner, businesses ensure their financial statements provide a more accurate picture of their financial position. This estimation often involves reviewing past experiences and historical data to predict future uncollectible accounts.

• This approach aligns with the matching principle, ensuring that all expenses related to the revenue generation are reported in the same period.
• The estimated amount is then adjusted against the Allowance for Doubtful Accounts, a contra-account attached to accounts receivable.

Understanding bad debts expense is essential for financial analysis, as it directly affects profit figures, often alerting to potential cash flow problems in a business.

Accounts Receivable

**Accounts Receivable** (AR) represents the outstanding invoices or money that is owed to a company by its customers. It's essentially a line of credit extended by a company, allowing customers to pay for goods and services at a later date. This asset is a critical component of a company's balance sheet, providing insight into future cash flows and overall business health.

AR can become problematic if not managed effectively. Companies often scrutinize their accounts receivable aging schedules to monitor outstanding payments and pursue collections as needed. Without active management, unpaid receivables can escalate, reducing available cash for operations.

• AR typically falls under current assets as they are usually settled within one year.
• It assures creditors of the company's liquidity, indicating how efficiently the firm is operating.

The efficient management of accounts receivable is crucial as it ensures steady cash inflows and reduces the risk of uncollectible amounts. Businesses strive to maintain a balance between sales growth and the quality of accounts receivable.

Uncollectible Accounts

**Uncollectible accounts** refer to those receivables deemed irrecoverable, which means the company will not be able to collect the money owed by its customers. This scenario is often unavoidable, as not all customers reliably pay their debts on time or at all. Such accounts are adjusted out of the accounts receivable through the allowance method, where estimated uncollectible amounts are recorded using an "Allowance for Doubtful Accounts."

The need to estimate uncollectible accounts arises from the desire to ensure that financial statements reflect realistic expectations. Businesses usually employ methods like aging schedules and historical analysis to assess which accounts might turn uncollectible. However, this requires regular inspection and adaptation to changing economic conditions and customer reliability.

• This method allows for a "bad debt reserve," acting as a buffer against future losses.
• Effective management of these accounts is critical, aiming to minimize potential risks and enhance financial stability.

Dealing with uncollectible accounts proactively helps maintain a healthy accounts receivable ledger and supports liquidity management, ultimately promoting better financial health for the company.