The concept of Uncollectible account in Accounting

While preparing the balance sheet, companies enlist accounts receivable in the category of asset as a current asset. However, the particular amount of that item which has to be report sometimes become intricate due to some receivables which are uncollectible.

Sellers usually have some credit requirements to the customers or the clients that need to be fulfilled to make the credit sale approved. In spite of these procedures some accounts receivable will definitely be uncollectible which (as a normal part of credit sales). For instance, a client is unable to pay due to lack of sales revenue or economical recession. Moreover, the debtor may be suffering from financial crises because of some unexpected expenses or lost of job.

To avoid this risk of uncollectible receivables, sometimes companies may transfer the risk of uncollectible receivables to other companies. For example, some sellers allow cash or credit cards for selling rather than sales on account which consequently alter the risk to the credit card companies. Furthermore, if a company (such as Macy’s or JCPenney) issues its own credit card then the company has the right to sell its receivable that is beneficiary for collecting instant cash.

Such credit losses are reported as debits to Bad Debts Expense or Uncollectible Accounts Expense or Doubtful Accounts Expense.

An account usually termed as uncollectible is case of following situation:

  • The client does not reply to the company to which he/she is owed.
  • The receivable is already in due status.
  • The company is failure to trace the customer.
  • The client closes its business or files for bankruptcy.
  • The remaining balance in the account after collected by collection agency is considered as uncollectible.

Companies generally use the two methods of accounting for recording uncollectible receivables which are follows:

  1. The direct write-off method (if an account is concluded to be of no value) and
  2. The allowance method (if uncollectible accounts are estimated at the end of the particular accounting period)

The Direct Write-off Method

The direct write-off method leads a company to recognize a particular account to be uncollectible indicting the loss to Bad Debts Expense.

As for example, on November 5 ABC Company writes off as uncollectible Mr. X $350 balance. The entry for this account will be as follows:

Nov. 5 Bad Debts Expense………….$350Accounts Receivable ………$350(To record write-off Mr. X)

The direct write off method allow only to reports the actual lossesfrom uncollectible at its gross amount. Under this method, companies may report bad debts expense in a period that is different from the period when revenue is recorded.

To record uncollectible accounts, direct write-off method basically used by the following companies or business:

  • Small companies
  • Companies with few receivables
  • Firms who sell most of their goods or services on cash
  • Businesses allow only MasterCard or VISA for selling
  • Businesses where receivables or bad debt expenses are considered as a small part of the current assets (ex- restaurant, convenience store small retail store etc.)

Though this method is easy to report the uncollectible receivables, it has some drawbacks, such as:

  • The direct write-off method does not provide assurance that bad debts expense will match to sales revenues in the income statement of any company.
  • The method reports the amount of accounts receivable in the balance sheet which is expected by the company to receive form the client.
  • The method is not useful for financial reporting functions until the expenses or losses of bad debts are worthless.
  • The direct write-off method can minimize the effectiveness of both the income statement and balance sheet.

If an account receivable is collected after written off then the account is put back by an entry that reverses the write-off entry and the cash payment is reported as a receipt on account.

For example, Mr.Y has an account of $2,000 which has written off on Feb 15 is later collected on September 20. The reinstatement and receipt of cash is recorded as follows:

Nov. 5 Accounts Receivable- Mr.Y………….$2,000      Bad Debts Expense………$2,000Cash………………$2,000         Accounts Receivable.………….$2,000

The Allowance Method

The allowance method of accounting for bad debts expense leads the company to estimate uncollectible accounts at the end of each period.

This allowance method is basically identified by three characteristics:

  1. Uncollectible accounts receivable or bed debt expenses are estimated by the company which they match against revenuesin the same accounting period when they recorded revenues.
  2. At the end of each period, estimated uncollectible are debited to Bad Debts Expense and credited to Allowance for Doubtful Accounts (a contra-asset account) by using an adjusting entry.
  3. If an accounts has written off by the company then they debit actual uncollectible to Allowance for Doubtful Accounts and credit to Accounts Receivable.

Based on the company’s estimation, Bad Debt Expense is recorded by using an adjusting entry which could be exemplified though the following example.

Suppose, in 2012 XYZ Company has credit sales of $200,000, out of which $50,000 is remains uncollected by the December 31. Company estimates that $10,000 of these credit sales will be uncollectible.

The adjusting entry for recording the estimated uncollectible is:

Dec. 31 Bad Debts Expense………….10,000Allowance for Doubtful Accounts………10,000(To record estimate of uncollectible accounts)

Companies prefer allowance method for the following features:

  • This method provides assurance of better matching on the income statement.
  • The allowance method leads the companies to report receivables on the balance sheet at their cash (net) realizable value whichis the net amount that the company expects to receive in cash.
  • This method reduces receivables by the amount of estimated uncollectible receivables in the balance sheet.
  • When bad debts expenses are material in amount, this method is required by GAAP for financial reporting purposes.

Bad Debts Expense is reported as an operating expense or selling expense in the income statement of XYZ Company which leads the estimated uncollectible to be matched with the sales occurred in 2012.

Allowance for Doubtful Accounts represents that estimated amount of claims on client which is expected by the company to be uncollectible in the future.

Companies generally prefer to use a contra account (which take up specific write-offs when they occur) rather than a direct credit to Accounts Receivable due to the uncertainty of the payment.

The allowance method is usually used by the companies with a large amount of receivables, for example, General Intel, Electric, FedEx, Pepsi and so on.

Recording the Write-Off of an Uncollectible Account

If the company realize that past due collections are impossible even after applying all the methods (ex-letters, calls) for collecting past due accounts then the company usually write off the account. Some industries have some standard procedures in writing off the due account, for example the credit card industry, they generally write off those accounts which are 210 days past due.

Every company should have some practices while writing off the past due accounts. Such as:

  • The person who will be responsible for writing off the account should not be related to cash or receivable activities of the company. This practice will ensure effective internal control.
  • The respective authority should consent for writing off after properly screening and evaluate the accounts in order to avoid any unauthorized accounts to be write-off.

The recording of write-off of an uncollectible account could be better exemplified by the following example:

The respective authority of ABC Company issue a write-off of an uncollectible account of the $1000 balance owed by Mr. Y on August 1, 2012.The entry to record the write-off is as follows:

August 1, 2012 Allowance for Doubtful Accounts ……$1000Accounts Receivable- Mr. Y ………$1000(To record write-off Mr. Y account)

The amount of Bad Debts Expense does not increase in accordance with the recording of write-off. The allowance method leads the companies to debit every bad debt write-off to the allowance account.If the company will debitto Bad Debts Expense then it wouldbe incorrect as the company has already realized the expense when itmade the adjusting entry for estimated bad debts. The recording of thewrite-off of an uncollectible account reduces the amount of both Accounts Receivable and theAllowance for Doubtful Accounts. A write-off affects only the accounts of balance sheet rather than income statement accounts which lead the cash realizable value to remain same as in the balance sheet.

After recording, the general ledger accounts willappear as follows:

Accounts Receivable

July. 1 Bal. 30,000.Nov 1 Bal. 15,000 Nov 1 Bal. 15,000

Allowance for Doubtful Accounts

Nov 1 Bal. 5,000 July. 1 Bal. 8,000

Nov 1 Bal.  5,000

Recovery of an Uncollectible Account.

The recovery of an uncollectible account is made by the company when any past due collected from a customer after written off the account. There are generally two entries to record the recovery of a bad debt which are as follows:

  1. Reverses the entry which is made in writing off the account in order to reinstates the customer’s account.
  2. Journalizes the collected amount of past due following the usual manner.

For example: on December 15, Mr. Y pays the $1000 amount that had been written off by the ABC Company on August 1.and and the entries are:

December 15, 2012 Accounts Receivable- Mr. Y ………$1000

Allowance for Doubtful Accounts …………$1000

(To reverse write-off Mr. Y account)

December 15,2012 Cash …………$1000

Accounts Receivable- Mr. Y ………$1000

(To record collection from Mr. Y account)

The recovery of a bad debt also affects only balance sheet accounts.

Estimating Uncollectible

As previously mentioned the allowance method always requires an estimate of uncollectible accounts at the end of the particular accounting period. This estimation of uncollectible is usually executed concerning three criterions, such as:

  • Past experience
  • Industry averages
  • Forecasts of the future

There are two typical methods are available for estimating the uncollectible. These both methods are generally acknowledged by the company. However, management selects the method that best matches with the situation.

A company can use either of the following to estimate the uncollectible:

  • a)  Percent of sales method.
  • b)  Percent of the receivables method.

Percent of Sales Method: the past due uncollectible accounts can be estimated as a percent of credit sales as accounts receivable occurred due to credit sales. Under this method company usually estimates what percentage of credit sales will be uncollectible based on past experience and expected credit policy applying to either total credit sales or net credit sales of the current year.

Percentage-of-Receivables: Under this method company estimates what percentage of receivables will result in losses from uncollectible accounts by creating an aging schedule which will recognize customer balances in accordance with the duration of past due time of uncollectible. Due to nature of the method, this procedure is also termed as aging the accounts receivable.