ACCOUNTING FOR UNCOLLECTIBLE RECEIVABLES
UNCOLLECTIBLE RECEIVABLES: Unfortunately, some sales on account may not be collected. Customers go broke, become unhappy and refuse to pay, or may generally lack the ethics to complete their half of the bargain. Of course, a company does have legal recourse to try to collect such accounts, but those often fail. As a result, it becomes necessary to establish an accounting process for measuring and reporting these uncollectible items. Uncollectible accounts are frequently called "bad debts."
DIRECT WRITE-OFF METHOD: A simple method to account for uncollectible accounts is the the direct write-off approach. Under this technique, a specific account receivable is removed from the accounting records at the time it is finally determined to be uncollectible. The appropriate entry for the direct write-off approach is as follows:
2-10-X7 Uncollectible Accounts Expense 500
Accounts Receivable 500
To record the write-off of an uncollectible account from Jones
Notice that the preceding entry reduces the receivables balance for the item that is deemed uncollectible. The offsetting debit is to an expense account: Uncollectible Accounts Expense.
While the direct-write off method is simple, it is only acceptable in those cases where bad debts are immaterial in amount. In accounting, an item is deemed material if is large enough to affect the judgment of an informed financial statement user. Accounting expediency sometimes permits "incorrect approaches" when the effect is not material. Recall the discussion of nonbank credit card charges above; there, the service charge expense was recorded subsequent to the sale, and it was suggested that the approach was lacking but acceptable given the small amounts involved. Again, materiality considerations permitted a departure from the best approach. But, what is material? It is a matter of judgment, relating only to the conclusion that the choice among alternatives really has very little bearing on the reported outcomes.
You must now consider why the direct-write off method is not to be used in those cases where bad debts are material; what is "wrong" with the method? One important accounting principle is the notion of matching. That is, costs related to the production of revenue are reported during the same time period as the related revenue (i.e., "matched"). With the direct-write off method, you can well understand that many accounting periods may come and go before an account is finally determined to be uncollectible and written off. As a result, revenues from credit sales are recognized in one period, but the costs of uncollectible accounts related to those sales are not recognized until another subsequent period (producing an unacceptable mismatch of revenues and expenses).
To compensate for this problem, accountants have developed "allowance methods" to account for uncollectible accounts. Importantly, an allowance method must be used except in those cases where bad debts are not material (and for tax purposes where tax rules often stipulate that a direct write-off approach is to be used). Allowance methods will result in the recording of an estimated bad debts expense in the same period as the related credit sales. As you will soon see, the actual write off in a subsequent period will generally not impact income.
ALTERNATIVE APPROACHES FOR UNCOLLECTIBLES
ALLOWANCE METHODS: Having established that an allowance method for uncollectibles is preferable (indeed, required in many cases), it is time to focus on the details. Let's begin with a consideration of the balance sheet. Suppose that Ito Company has total accounts receivable of $425,000 at the end of the year, and is in the process or preparing a balance sheet. Obviously, the $425,000 would be reported as a current asset. But, what if it is estimated that $25,500 of this amount may ultimately prove to be uncollectible.
The total receivables are reported, along with an allowance account (which is a contra asset account) that reduces the receivables to the amount expected to be collected. This anticipated amount to be collected is often termed the "net realizable value."
DETERMINING THE ALLOWANCE ACCOUNT: In the preceding illustration, the $25,500 was simply given as part of the fact situation. But, how would such an amount actually be determined? If Ito Company's management knew which accounts were likely to not be collectible, they would have avoided selling to those customers in the first place. Instead, the $25,500 simply relates to the balance as a whole. It is likely based on past experience, but it is only an estimate. It could have been determined by one of the following techniques:
AS A PERCENTAGE OF TOTAL RECEIVABLES:
12-31-X5 Uncollectible Accounts Expense 15,500
Allow. for Uncollectible Accounts 15,500
To adjust the allowance account from a $10,000 balance to the target balance of $25,500 ($25,500 - $10,000)
You should carefully note two important points: (1) with balance sheet approaches, the amount of the entry is based upon the needed change in the account (i.e., to go from an existing balance to the balance sheet target amount), and (2) the debit is to an expense account, reflecting the added cost associated with the additional amount of anticipated bad debts.
Rather than implement a balance sheet approach as above, some companies may follow a simpler income statement approach. To illustrate, assume that Pick Company had sales during the year of $2,500,000, and it records estimated uncollectible accounts at a rate of 3% of total sales. Therefore, the appropriate entry to record bad debts cost is as follows:
12-31-X5 Uncollectible Accounts Expense 75,000
Allow. for Uncollectible Accounts 75,000
To add 3% of sales to the allowance account ($2,500,000 X 3% = $75,000)
WRITING OFF UNCOLLECTIBLE ACCOUNTS: Now, we have seen how to record uncollectible accounts expense, and establish the related allowance. But, how do we write off an individual account that is determined to be uncollectible? This part is easy. The following entry would be needed to write off a specific account that is finally deemed uncollectible:
3-15-X3 Allow. for Uncollectible Accounts 5,000
Accounts Receivable 5,000
To record the write-off of an uncollectible account from Aziz
Notice that the entry reduces both the allowance account and the related receivable, and has no impact on the income statement. Further, consider that the write-off has no impact on the net realizable value of receivables, as shown by the following illustration of a $5,000 write-off:
COLLECTION OF AN ACCOUNT PREVIOUSLY WRITTEN OFF: On occasion, a company may collect an account that was previously written off. For example, a customer that was once in dire financial condition may recover, and unexpectedly pay an amount that was previously written off. The entry to record the recovery involves two steps: (1) a reversal of the entry that was made to write-off the account, and (2) recording the cash collection on the account:
6-16-X6 Accounts Receivable 1,000
Allow. for Uncollectible Accounts 1,000
To reestablish an account previously written off via the reversal of the entry recorded at the time of write-off
6-16-X6 Cash 1,000
Accounts Receivable 1,000
To record collection of account receivable
MATCHING ACHIEVED: Carefully consider that the allowance methods all result in the recording of estimated bad debts expense during the same time periods as the related credit sales. These approaches satisfy the desired matching of revenues and expenses.
