Final answer:
It is true that a debit balance in allowance for doubtful accounts indicates underestimation of bad debts. This can happen when a bank experiences higher-than-expected loan defaults, potentially leading to negative net worth if the shortfall is substantial.
Step-by-step explanation:
Allowance for Doubtful Accounts
The statement that a debit balance in allowance for doubtful accounts indicates the estimate for bad debts was too low is true. Allowance for doubtful accounts is a contra-asset account used to estimate the portion of a bank's loan portfolio that is likely not to be repaid. When actual defaults exceed the estimated amount, it leads to a debit balance in this allowance, revealing that the prediction for bad debts was underestimated. This situation can occur in scenarios where loan defaults rise significantly, such as during a recession, and the estimated bad debt provision falls short of the actual experience. For instance, if a bank like the hypothetical Safe and Secure Bank experiences a surge in loan defaults, reducing the valuation of its loans and leading to a diminished asset value, it can end up with a negative net worth.
A debit balance in allowance for doubtful accounts indicates that the estimate for bad debts was too low. This statement is true.
The allowance for doubtful accounts is a contra asset account that reduces the accounts receivable account on the balance sheet.
If the debit balance in the allowance for doubtful accounts increases, it means that more bad debts have been estimated and recognized, indicating that the estimate for bad debts was too low.