Difference between Expense and Allowance

The account Bad Debts Expense reports the credit losses that occur during the period of time covered by the income statement. Bad Debts Expense is a temporary account on the income statement, meaning it is closed at the end of each accounting year. (Closed means the account balance is transferred to retained earnings, perhaps through an income summary account.) By closing Bad Debts Expense and resetting its balance to zero, the account is ready to receive and tally the credit losses for the next accounting year.

The Allowance for Doubtful Accounts reports on the balance sheet the estimated amount of uncollectible accounts that are included in Accounts Receivable. Balance sheet accounts are almost always permanent accounts, meaning their balances carry forward to the next accounting period. In other words, they are not closed and their balances are not reset to zero.

Because the Bad Debts Expense account is closed each year, while the Allowance for Doubtful Accounts is not, these two balances will most likely not be equal after the company's first year of operations.

Pledging or Selling Accounts Receivable

A company's accounts receivable are considered to be a type of asset, and as such can be pledged as collateral for a loan. Asset-based lenders will often lend a company an amount equal to 80% of the value of its accounts receivable.

Some companies sell their accounts receivable to a factor. A factor buys the accounts receivables at a discount and then goes about the business of collecting and keeping the money owed through the receivables. Sometimes the factor will purchase the accounts receivables with recourse. This means the company that sold the receivables remains financially responsible if a customer does not remit the full amount to the factor. When the factor purchases the receivables without recourse, the company selling the receivables is not responsible for unpaid amounts.

2. Complete the following sentences

1. Collections of amounts from customers who had purchased on credit are ___________ to Accounts Receivable.

2. When sales terms are FOB______________ title passes at the buyer's location.

3. The valuation account associated with Accounts Receivable is the _____________ for Doubtful Accounts.

4. When terms are 2/10, n/30, the seller is allowing a 2% _________ if the invoice is paid within 10 days.

5. Sorting the accounts receivable according to the dates of the sale invoices is the _________ of accounts receivable.

6. The percentage of ______________ method for bad debts focuses on the balance reported in the allowance account.

7. The percentage of ______ method for bad debts focuses on the expense reported on the income statement.

8. The _________ write-off method for bad debts is required for income tax purposes.

9. Accounts receivable is reported as a __________ asset.

10. Annual credit sales divided by the average balances in accounts receivable is the receivables _________________ ratio.

3. Choose the correct answer

1. On June 1, $800 of goods are sold with credit terms of 1/10, n/30. How much should the seller expect to receive if the buyer pays on June 8?

a) $720

b) $784

c) $792

d) $800

2. On June 1, $800 of goods are sold with credit terms of 1/10, n/30. On June 3 the customer returned $100 of the goods. How much should the seller expect to receive if the buyer pays on June 8?

a) $692

b) $693

c) $700

d) $792

3. When the Allowance for Doubtful Accounts appears on a company's financial statements, its balance will be a __________ balance.

a) debit

b) credit

4. On which financial statement would you expect to find Allowance for Doubtful Accounts?

a) balance sheet

b) income statement

5. Which method of reporting losses on accounts receivable is required in the U.S. for income a) a) tax purposes?

b) allowance

c) direct write-off

6. Which method of reporting losses on accounts receivable is to be used for financial reporting?

a) allowance

b) direct write-off

7. The seller of goods that is offering credit terms of net 30 days will likely be one of its customer's _____________ creditors until it receives payment.

a) secured

b) unsecured

8. After several years of operations, a company's Bad Debts Expense for a given year is likely to be the same as its balance in Allowance for Doubtful Accounts.

a) True

b) False

9. A company estimates that $20,000 of its $500,000 of accounts receivable will be uncollectible. Its Allowance for Doubtful Accounts presently has a credit balance of $8,000. The adjusting entry will include a ___________________ to the Allowance for Doubtful Accounts.

a) debit of $12,000

b) credit of $12,000

c) debit of $28,000

d) credit of $28,000

10. A company estimates that $20,000 of its $500,000 of accounts receivable will be uncollectible. Its Allowance for Doubtful Accounts presently has a credit balance of $18,000. The adjusting entry will include a ____________________ to Bad Debts Expense.

a) debit of $2,000

b) credit of $2,000

c) debit of $38,000

d) credit of $38,000

11. A company estimates that $20,000 of its $500,000 of accounts receivable will be uncollectible. Its Allowance for Doubtful Accounts presently has a debit balance of $3,000. The adjusting entry will include a _____________________ to Allowance for Doubtful Accounts.

a) debit of $3,000

b) credit of $3,000

c) debit of $17,000

d) credit of $17,000

e) debit of $23,000

f) credit of $23,000