Final answer:
The correct answer is the Allowance for Doubtful Accounts, a contra asset account associated with Accounts Receivable and Bad Debts Expense.
Step-by-step explanation:
This contra asset account is associated with Accounts Receivable and Bad Debts Expense. It reports the estimated amount of the receivables that will not be collected. The correct answer to this question is the Allowance for Doubtful Accounts.
This account is used by businesses to anticipate and plan for the potential of not receiving payments from customers. The Allowance for Doubtful Accounts is an estimate and is used to create a more accurate picture of a company's financial health.
In accounting, businesses must recognize that not all credit sales will result in cash. The creation of the Allowance for Doubtful Accounts allows businesses to 'match' expenses with revenues in the same accounting period, a fundamental principle known as the matching principle.
The entry to record the estimation of bad debts is a debit to Bad Debts Expense and a credit to Allowance for Doubtful Accounts, which is subtracted from Accounts Receivable on the balance sheet. If actual bad debts are later identified, the business will write off the specific amount against the previously established allowance.
For a bank, the principle is similar. As mentioned with the example of the Safe and Secure Bank, if loan default rates are higher than expected, it can lead to a decrease in asset values and potentially a negative net worth. Having an allowance for such defaults is crucial to manage the risks associated with lending.