What if a Company’s Allowance for Doubtful Accounts is Understated / Overstated

To Answer This Question, Let’us Consider the two different cases with simple example as shown below:

Case 1: What if a company’s Allowance for Doubtful Accounts is Understated | Allowance For Doubtful Accounts Wrongly Understated

When this happens, then Allowance For Doubtful Accounts shows less Closing Balance on Debit Side (Credit Balance) on its Ledger and hence as a result the amount of Contra Asset Account i.e., Allowance For Doubtful Accounts that is deducted from Closing Balance of Accounts Receivable on Balance Sheet will make accounts receivable's Net Relizable Value overstated. Also Net Income / Net Profit will also be overstated due to less recorded amount of Uncollectible Accounts Expense / Doubtful Debts on Income Statement.

Understanding on How To Rectify this Wrong Reporting By Using a Simple Example

(Here Net Income = Rs. 500000)

In order to Rectify this wrong reporting, there is needed to add more value to the Allowance For Doubtful Accounts by credited it with the value required to add i.e. if we wrongly charged 2% Net Income instead of 5%, then 3% of Net Income or Accounts Receivable is added to the amount of Allowance For Doubtful Accounts by Credited it.

The Rectifying Journal Entry is passed (Assuming 3% on Net Income):

        Uncollectible Accounts Expense a/c    15000

                                                                 Allowance For Doubtful Accounts a/c    15000

(Allowance For Doubtful Account on Net Income is Estimated)

Allowance For Doubtful Accounts 2% on Net Income Wrongly Reported = 2% X 500000 = Rs. 10000

Add: Further More 3% X 500000 = 15000

Total Allowance For Doubtful Accounts = 10000 + 15000 = Rs.25000

Thus Rs. 15000 is more needed to added in order to correct the overstated Net Relizable value of Accounts Receivable and Net Income.

You Can Also Study About, “What is a Debit Balance In The Allowance For Doubtful Accounts”

Case 2: What if a company’s Allowance for Doubtful Accounts is Overstated | Allowance For Doubtful Wrongly Overstated

In this situation, it is the reversal of the above mentioned case i.e., the allowance of Doubtful Accounts show more Closing Balance on Debit Side (Credit Balance) and as a result the Net Realizable value of Accounts Receivable understated. Also Net Income is understated due to more amount of Uncollectible Accounts Expense / Doubtful Debts is recorded on Income Statement. To Rectify this wrong reporting, we need to deduct the excess amount from Allowance For Doubtful Accounts by debited it. For Example if we wrongly estimated 7% instead of 5% in above mentioned example, then we need to pass following Rectifying Journal Entry:

     Allowance For Doubtful Accounts a/c    10000

                                                                 Uncollectible Accounts Expense a/c    10000

(Excess Amount of Allowance For Doubtful Accounts Deducted By Debited It)

So, it is all about the two different cases of recording Understated and Overstated Value of Allowance For Doubtful Accounts / Provision For Doubtful Debts and how to rectify these wrong reporting by passing Rectifying Accounting Journal Entries.