Final answer:
Expenses are understated if a company fails to record estimated bad debt expense, as it does not adequately anticipate the percentage of accounts receivable that may not be collected.
Step-by-step explanation:
When a company fails to record estimated bad debt expense, they are understating their expenses. Estimated bad debt expense is an anticipated expense, reflecting the percentage of accounts receivable that are expected not to be collected. A well-run bank, for example, assumes that some borrowers will not repay their loans and includes a factor for these uncollected loans as part of the bank’s annual expenses. The balance sheet reflects this in the value of the bank’s loans, inherently acknowledging a certain level of risk due to unrepaid loans. During a financial downturn, such as a recession, a higher rate of loan defaults can occur, and if the bank had not accurately estimated the bad debt expense, it could result in significant financial distress. Conversely, ignoring accrued liabilities also results in expenses being understated, as these are obligations that have been incurred but not yet paid or recorded on the financial statements.