Extending credit to customers represents an inherent risk to any business. The possibility of the accounts receivable being uncollectible is caused mainly because the client is unable to attend his or her liabilities as they come due. Unwillingness could be the other reason.
To reflect a realistic balance of the accounts receivable in the balance sheet is necessary to make an entry that reduces that amount and brings the balance to the amount more likely to be collected. Through an entry (credit) to the Allowance for Uncollectible Accounts, which is a Contra-Asset Account, the balance of accounts receivable shown in the balance sheet is conservative and does not create false expectations to the users of financial statements.
For example, if the Company Lives’ Saver, Inc. has accounts receivable for $65,000 and, based on past experiences, $3,500 will probably not be collected. With the purpose of preserving the original information, the total amount of accounts receivable is shown in the balance sheet as follows:
Accounts Receivable $65,000
Less: Allowance for Uncollectible Accounts ($ 3,500)
Net Realizable Value $61,5000
In alignment with the Revenue Recognition Principle that requires that revenues be recorded in the time period when the work is performed, and the earnings process is complete, and with the Matching Principle that requires that expenses be recorded in the same time period as the revenues they helped generate, it helps prevent the “cooking of the books,” by timely recording expenses.
There are two methods generally accepted for recognizing the amount of uncollectible receivables and the related bad debt expense:
1) Percentage-of-Sales Method
2) Percentage-of-Receivables Method.
Regardless of the allowance method used, the same enty is used to record the bad debt expense:
Bad Debt Expense (Dr) xxx
Allowance for Uncollectible Accounts(Cr) xxx
Regardless of the allowance method used to estimate uncollectible receivable, the amounts written off are recorded as follows:
Allowance for Uncollectible Accounts (Dr) xxx
Accounts Receivables (cr)xxx
If an account previously written off is collected the entry to reflect this bears no effect on net income, current assets, or working capital. The entries are:
a) To reopen the account receivable written off:
Accounts Receivable (Dr) xxx
Allowance for Uncollectible Accounts (Cr) xxx
b) To record the receipt of cash in partial payment of the receivables:
Cash (Dr) xxx
Account Receivables (Cr) xxx
The allowance method of recording uncollectible accounts matches the account expense with the revenue generated by credit sales in the same period, which means that this method is consistent with accrual accounting. The direct write-off method is not consistent with accrual accounting because the write off of an account receivable takes places in a period after the revenues were generated.
The direct write-off method of recognizing bad debt expense requires the identification of amounts considered uncollectible before any bad expense is recognized. This method does not match the cost of selling on account with the revenues generated by the sale. Accounts receivable are recorded at an amount higher than its net realizable value.