Write-offs
Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. This phenomenon is known, in the realm of accounting, as bad debt.
Companies use two methods for handling uncollectible accounts: the direct write-off method and the allowance method. The direct write-off method is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger. The bad debt is recognized as an expense at the point when judged to be uncollectible.
When using the allowance method, an estimate is made at the end of each fiscal year of the amount of bad debt. This amount is accumulated in a provision, which is then used to reduce specific receivable accounts when necessary. Note that the allowance method is the required method for federal income tax purposes (GAAP).
Uncollectibles
Interesting Facts About Collection Agencies.
Because of the matching principle of accounting, revenues and expenses should be recorded in the period in which they are incurred. When a sale is made on account, revenue is recorded along with account receivable. Because there is an inherent risk that clients might default on payment, accounts receivable have to be recorded at net realizable value. The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for Doubtful Accounts. At the end of each accounting cycle, adjusting entries are made to charge uncollectible receivable as expense. The actual amount of uncollectible receivables is written off as an expense from Allowance for Doubtful Accounts.
Allowance Method Example
As time passes and a firm considers a specific customer's account to be uncollectible, it writes that account off. It debits the Allowance for Doubtful Accounts. The credit is to the Accounts Receivable control account in the general ledger and to the customer's account in the accounts receivable subsidiary ledger. For example, assume Smith's USD 750 account has been determined to be uncollectible. The entry to write off this account is:
Allowance for Uncollectible Accounts (-SE) 750
Accounts Receivable—Smith (-A) 750
The credit balance in Allowance for Doubtful Accounts before making this entry represented potential uncollectible accounts not yet specifically identified. Debiting the allowance account and crediting Accounts Receivable shows that the firm has identified Smith's account as uncollectible. Notice that the debit in the entry to write off an account receivable does not involve recording an expense. The company recognized the uncollectible accounts expense in the same accounting period as the sale. If Smith's USD 750 uncollectible account were recorded in Uncollectible Accounts Expense again, it would be counted as an expense twice.
A write-off does not affect the net realizable value of accounts receivable. For example, suppose that Amos Company has total accounts receivable of USD 50,000 and an allowance of USD 3,000 before the previous entry; the net realizable value of the accounts receivable is USD 47,000. After posting that entry, accounts receivable are USD 49,250, and the allowance is USD 2,250; net realizable value is still USD 47,000, as shown here:
Before Write-Off // Entry for After Write-Off // Write-Off
Accounts receivable 50,000 Dr. // 750 Cr. // $ 49,250 Dr.
Allowance for uncollectible accounts 3,000 Cr. // 750 Dr. // 2,250 Cr.
Net realizable value 47,000 Dr. // $47,000
You might wonder how the allowance account can develop a debit balance before adjustment. To explain this, assume that Jenkins Company began business on January 1, 2009, and decided to use the allowance method and make the adjusting entry for uncollectible accounts only at year-end. Thus, the allowance account would not have any balance at the beginning of 2009. If the company wrote off any uncollectible accounts during 2009, it would debit Allowance for Uncollectible Accounts and cause a debit balance in that account. At the end of 2009, the company would debit Uncollectible Accounts Expense and credit Allowance for Uncollectible Accounts. This adjusting entry would cause the allowance account to have a credit balance.
During 2010, the company would again begin debiting the allowance account for any write-offs of uncollectible accounts. Even if the adjustment at the end of 2009 was adequate to cover all accounts receivable existing at that time that would later become uncollectible, some accounts receivable from 2010 sales may be written off before the end of 2010. If so, the allowance account would again develop a debit balance before the end-of-year 2010 adjustment.