Can the bad debt expense be negative?

If you are writing off uncollectible accounts receivable as they occur (the direct charge-off method), then there will be times when a customer unexpectedly pays an invoice after you have written it off. In such a case you reverse the write-off, which will yield a negative bad debtexpense if the original write-off occurs in a month earlier than the reversal. On the other hand, if you are using the allowance method and charging an estimated amount to bad debt expense each month, an unexpected customer payment may not result in a reversal of the original bad debt expense. Instead, since the assumption behind the allowance method is thatsome receivable will not be collectible (we just don't know which one), you would normally not reduce the balance in the allowance for doubtful accounts. Thus, the method you are using to record bad debts will be the key determining factor in whether or not you will ever experience a negative bad debt expense.

What is the difference between bad debt and doubtful debt?

A bad debt is an account receivable that has been clearly identified as not being collectible. This means that you remove that specific account receivable from the accounts receivable account, usually by creating a credit memo in the billing software and then matching the credit memo against the original invoice, which removes both the credit memo and the invoice from the accounts receivable report. When you create the credit memo, you credit the accounts receivable account and debit either the bad debt expense account (if there is no reserve set up for bad debts) or the allowance for doubtful accounts (which is a reserve account that is set up in anticipation of bad debts). The first alternative for creating a credit memo is called the direct write off method, while the second alternative is called the allowance method for doubtful accounts. A doubtful debt is an account receivable that might become a bad debt at some point in the future. You may not even be able to specifically identify which open invoice to a customer might be so classified. In this case, you create a reserve account for accounts receivable that may eventually become bad debts, estimate the amount of accounts receivable that may become bad debts in any given period, and create a credit to enter the amount of your estimate in this reserve account, which is known as the allowance for doubtful accounts. The debit in the transaction is to the bad debt expense. When you eventually identify an actual bad debt, you write it off (as described above for a bad debt) by debiting the allowance for doubtful accounts and crediting the accounts receivable account. For example, ABC International has $100,000 of accounts receivable, of which it estimates that $5,000 will eventually become bad debts. It therefore charges $5,000 to the bad debt expense (which appears in the income statement) and a credit to the allowance for doubtful accounts (which appears just below the accounts receivable line in the balance sheet). A month later, ABC knows that a $1,500 invoice is indeed a bad debt. It creates a credit memo for $1,500, which reduces the accounts receivable account by $1,500 and the allowance for doubtful accounts by $1,500. Thus, when ABC recognizes the actual bad debt, there is no impact on the income statement - only a reduction of the accounts receivable and allowance for doubtful accounts line items in the balance sheet (which offset each other).

What is the direct write off method?

The direct write off method is the practice of charging bad debts to expense in the period when individual invoices have been clearly identified as bad debts. The specific activity needed to write off an account receivable under the direct write off method with accounting software is to create acredit memo for the customer in question, which exactly offsets the amount of the bad debt. Creating the credit memo will involve a debit to a bad debt expense account and a credit to the accounts receivable account. The method does not involve a reduction in the amount of recorded sales, only the increase of the bad debt expense. For example, a business records a sale on credit of $10,000, and records it with a debit to the accounts receivable account and a credit to the sales account. After two months, the customer is only able to pay $8,000 of the open balance, so the seller must write off $2,000. It does so with a $2,000 credit to the accounts receivable account and an offsetting debit to the bad debt expense account. Thus, the revenue amount remains the same, the remaining receivable is eliminated, and an expense is created in the amount of the bad debt. This approach violates the matching principle, under which all costs related to revenue are charged to expense in the same period in which you recognize the revenue, so that the financial results of an entity reveal the entire extent of a revenue-generating transaction in a single accounting period. The direct write off method delays the recognition of expenses related to a revenue-generating transaction, and so is considered an excessively aggressive accounting method, since it delays some expense recognition, making a reporting entity appear more profitable in the short term than it really is. For example, a company may recognize $1 million in sales in one period, and then wait three or four months to collect all of the related accounts receivable, before finally charging some items off to expense. This creates a lengthy delay between revenue recognition and the recognition of expenses that are directly related to that revenue. Thus, the profit in the initial month is overstated, while profit is understated in the month when the bad debts are charged to expense. The direct write off method can be considered a reasonable accounting method if the amount that is written off is an immaterial amount, since doing so has minimal impact on an entity's reported financial results. The alternative to the direct write off method is to create a provision for bad debts in the same period that you recognize revenue, which is based upon an estimate of what bad debts will be. This approach matches revenues with expenses, and so is considered the more acceptable accounting method. The direct write off method is required for the reporting of taxable income in the United States, since the Internal Revenue Service believes (possibly correctly) that companies would otherwise be tempted to inflate their bad debt reserves in order to report a smaller amount of taxable income. Similar Terms The direct write off method is also known as the direct charge-off method.

In auditing accounts receivable and related revenue balances, several potential problems exist that could create material misstatements. Some of these would be errors whereas others would indicate fraud. A set of basic internal control should be in place to prevent such erroneous or frauds from happening and a serial of substantive test to be conducted by auditors to make sure the accounts receivables balances are free of misstatement.

Most Common Errors and Frauds In Accounts Receivable and Revenues

Here are most common errors and frauds in accounts receivable that potentially result in accounts receivable misstatement: Reported receivables and sales could be false. Amounts were recorded to manipulate reported amount of income. False sales are especially likely if: (1) income to be reported is down for the period, (2) employee compensation or bonuses are based on profits, or (3) company plans to issue capital stock or borrow money in the near future. Incoming cash is stolen and theft is hidden. It is done by unethical custodians by writing off the receivable as a bad debt. Lapping is being carried out. Cash from one receivable is stolen and covered with cash received from a second customer during the following day or two. The year-end cut-off of transactions is incorrect. Transactions occurring before the end of year could be recorded in the subsequent period (thus, reporting for the initial year is not complete). Transactions after the end of year could be recorded prematurely in the initial year (reported transactions in initial year did not actually exist at the time of the financial statements). Customer is billed incorrectly (because of math errors, wrong quantity, wrong price, wrong items) or customer is just not billed at all for goods that were actually shipped (inventory is gone but no collection is ever made). Transaction is with a related party so that disclosure is needed.

Basic Internal Control for Accounts Receivables

Company should have a system in place to record sale, make proper shipment, and control and collect receivable balance to prevent such erroneous or fraudulences. Here are a basic internal control set for accounts receivable and related revenues: A customer order is received. May be by mail or over telephone or given directly to company employees. On a pre-printed, pre-numbered sales order form, the sales department lists all relevant information: quantity, description, terms, buyer, address, method of payment, etc. Credit department reviews credit file (which can hold credit report, references, financial statements, payment history of client, etc.). Approval or disapproval of credit is then indicated on the sales order form. If approved, sales order goes to finished goods warehouse where goods are gathered and sent to shipping department. Separate departments are maintained so that goods being removed must be documented.

Since asset is being transferred, shipping department should verify description and quantity against sales order form. Condition of goods should also be checked. Shipping then signs and returns a copy of sales order which is kept by warehouse as a receipt to prove that transfer was made. Shipping department sends goods to customer and prepares a shipping document, often known as a bill of lading. One copy goes with merchandise and a second copy is sent directly to customer. Copy of bill of lading [or air way bill] sent to inventory accounting department which should maintain a perpetual listing of all inventory. An entry is made to remove item from records. Entries are accumulated and forwarded to general accounting department for posting of the overall reduction of Inventory account. Copies of all documents go to billings department. Comparison is made of quantity and description. If all information agrees, a sales invoice is prepared and sent to client. It is also recorded in sales journal. Summary of sales journal is forwarded to general accounting for recording. Copy of sales invoice is sent to accounts receivable department. Amount is recorded in accounts receivable master file by customer name. Periodically, an aged accounts receivable trial balance is prepared which lists each account by age. Old accounts are turned over to a collection department. If balance still proves to be uncollectible, both collection and accounts receivable departments file documentation to indicate actions taken. Independent party reviews information before final write-off of balance is approved.

Substantive Testing Procedures for Accounts Receivable Balances

A number of substantive testing procedures should be performed to verify the assertions made by client about accounts receivable and related balances: Perform analytical procedures to identify areas where client figures differ from auditor expectations. Look at: overall balance of each account, age of receivables, gross profit percentage, sales returns as a percentage of sales, write off of accounts as compared to previous years, etc. Analytical procedures are required in planning stage of audit to help assess inherent risk. They are also required in final review stage of audit as a last check. Use as a substantive test of an account balance is optional. Trace one or more transactions through the entire system to see if recording is appropriate at each step. Start with customer order and check all steps until account and collection are recorded. Auditor is especially interested that all shipments are properly billed. Whenever auditor starts with transactions at their inception, the completeness assertion is being tested.

Vouch one or more entries in the T-account back through system to see if there is adequate support. Whenever auditor starts with a reported balance and seeks corroboration, the existence assertion is being tested.

Check math and accuracy of client work where applicable. Re-add accounts receivable master file and compare it to the general ledger account. Verify that aged accounts receivable trial balance is added correctly and individual amounts agree with master file.

For three to four days before and three to four days after year-end, verify client cut-off procedures to make sure transactions were recorded in correct period. Use the bill of lading and sales invoice to determine when receivable and sale should be recorded. Cash receipts listing provides date for removal of receivable.

Auditor reviews any evidence generated in subsequent period (the time from the balance sheet date until the end of fieldwork). For example, cash collections prove the balance and collectibility of a receivable and sales return should be matched with sales, and bad debts written off may have been uncollectible at years end.

Look for related party transactions that have to be disclosed. For example, the representation letter asks about their existence. Confirm balances directly with customers to prove existence assertion. Usually done early in audit unless inherent and/or control risks are high. In that case, confirmation is carried out closer to years end. All confirmations are signed by client but controlled, mailed, and responses received by auditor. Negative confirmations ask customer for a response only if reported balance is wrong. It is less costly but provides a poorer quality of evidence since nothing tangible is received unless a problem exists. Normally used for small balances, balances that are not old, and where risk appears low.

Positive confirmations ask for response from customer whether balance is correct or incorrect. Because an actual response should be received in all cases, this is viewed as a better technique. Normally used for old balances, large balances, or where risk is high.

If no response to positive request is received, a second confirmation can be sent or a direct call made. If auditor still does not get a response, alternative testing must be expanded. All documents should be compared and cash receipts should be reviewed for subsequent payment. In either type of confirmation, reported discrepancies should be investigated to determine whether a problem exists.

Accounts which have been written off or which have a zero balance can be confirmed just to make certain that reported facts are accurate. If a confirmation is returned by e-mail or by fax, the auditor may need to call the customer or request that the confirmation be mailed to the auditor in order to get adequate support.

Method of estimating bad debt expense should be examined. Auditor wants to make sure that no evidence exists to indicate that clients estimation is not justified. Auditor must be aware of changes that may affect clients previous experience.

Auditor must ensure balance sheet presentation and disclosure is appropriate. For example, pledged accounts must be noted.