Reference no: EM132323933

Bad Debt Expense and the Allowance for Bad Debts

Assume you are the controller of a large medical equipment company that sells diagnostic machinery to hospitals in the local geographic region.

You are currently training new employees, and in a recent training session, you report that total credit sales for the year is $300,000, accounts receivable total $40,000 less a $2,000 allowance for bad debts, and bad debt expense is $3,500. After the session, a trainee approaches somewhat confused about why bad debt expense and the allowance balance differ.

Interest on Notes Receivable

Interest Calculations:

Interest is the amount of money that is paid for the use of money that has been borrowed or to delay re-payment on debt obligations. In the table below, four notes are listed with the amount of original principal (amount borrowed), the interest rate (amount paid to borrow money) and the interest period for 2017.

Notes receivable for 2017:

Original Principal          Interest Rate          Interest Period During 2017    Note 1

$40,000                           6%                               3 months              Note 2

$15,000                           10%                             180 days               Note 3

$5,000                             8%                               90 days                Note 4

$250,000                          7%                               9 months

Accounts Receivables are the balances receivable from customer for credit sales made. Often, there are cases where these amounts are uncollectible due to circumstances beyond the control of the customer.

In order to ensure such cases are reflected in the financial statements, companies usually create an "allowance for bad debts" to reduce the accounts receivable balance. "Allowance for Bad debts" is a contra-asset account (i.e) a negative asset account.

Hence the net balance of accounts receivables and allowance for bad debts is reflected in the balance sheet under the asset section. In the above example this amount is 40000 - 2000 = 38000.

In order to create an allowance for bad debt without directly affecting the accounts receivbale balance, we need to debit an expense account. The entry would be:

Debit - Bad Debts Expense

Credit - Allowance for bad debts

As seen above, Bad debts expense is an expense account shown in the profit and loss statement while the allowance for bad debts is a contra-asset account shown in the balance sheet.

The Bad debts expense is essentially the change in the allowance for bad debts during the year. The allowance for bad debts represents the actual year-end balance that is to be reported. In the above case the bad debts expense is 3500. This would mean that the allowance for bad debts was a -1500 to which 3500 was added to arrive at the closing allowance of 2000.

Part II

All the notes are short term(less than 1 year) hence simple interest can be calculated.

Interest is calculated as Principal Amount X Interest Rate X Period Outstanding/1 year

Hence:

Note 1:

Interest = 40000 X 6% X 3 Months/12 Months = 600

Note 2:

Interest = 15000 X 10% X 180/360 = 750

Note 3:

Interest = 5000 X 8% X 90/360 = 100

Note 4:

Interest = 250000 X 7% X 9/12 = 13125

Total Revenue from Notes Receivable = 600 + 750 + 100 + 13125 = 14,575