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In advance of the upcoming community association budget season, I posted on one of the Linked-In groups to which I subscribe a query on whether associations utilize a bad debt line item in their annual budgets. Numerous industry experts, from managers to CPAs, provided insightful and valuable responses, some of which I’d like to share here.
The respondents universally agreed that in today’s turbulent economic climate, a condominium or homeowner association should include a bad debt line item in their annual budget. Mitch Drimmer pointed out that before an association can put in a number for bad debt, “bad debt” must be defined. “There is debt that is absolutely collectible and there is debt that is possibly collectible and then there is stone cold bad debt. How do you define and how do you calculate it?”
CPA Heather Clark responded to Mitch’s question by stating the following:
There are two aspects of bad debt from an accounting perspective. There is the allowance for doubtful accounts and there is bad debt expense which is the charge that adjusts the allowance for doubtful accounts:
1. What is an allowance for doubtful accounts?
a. An allowance for doubtful accounts is an estimate of the amount in your receivables that will not be collected.
b. The receivable account is an asset account and the allowance for doubtful accounts is a contra asset account i.e. an account that reduces the balance of the receivable account. So if the receivable balance is $100,000 and the allowance is $25,000 the net receivables on the books is $75,000.
2. What is bad debt expense?
a. Bad debt expense is the expense charge for increasing the allowance account which reduces net income (revenues less expenses).
b. So using the example above, if at December 31, 2009 the allowance for doubtful accounts is $100,000 and it is determined that at July 31, 2010 the allowance needs to be $130,000, then assuming no other adjustment to the allowance in the year 2010, the bad debt expense to be booked in July would be $30,000 (increase to $130,000 from $100,000).
Having an allowance for doubtful accounts does not mean all the accounts reserved for are uncollectible. Some may be fully collectible while others are partially collectible and others may not be collectible at all. Determining the amount needed in an allowance for doubtful account is an estimate which requires judgment. It is important determining the adequacy of the allowance for doubtful accounts that collection practices and legal action being taken be considered. If no legal action is taken accounts that are collectible may become uncollectible while legal action may result in accounts being wholly or partially collectible.