What happens when accounts receivable are not collected?

The Allowance for Uncollectible Accounts or Allowance for Doubtful Accounts is a contra asset account that reduces the amount of accounts receivable to the amount that is more likely be collected.

The income statement account Bad Debts Expense is part of the adjusting entry that increases the balance in the Allowance for Uncollectible Accounts.

Effect of No Allowance for Uncollectible Accounts

If a company's balance sheet does not reduce its accounts receivable debit balance with a credit balance in Allowance for Uncollectible Accounts, the company is communicating that it is not anticipating any bad debts expense relating to its existing accounts receivable. Hence, the income statement is delaying the reporting of bad debts expense on its income statement until an account receivable is actually written off as uncollectible.

When a business operates by making sales on credit, it faces the risk that it will not be able to collect on some of the obligations. While it is easy to identify an uncollectible receivable as a recorded sale for which you will be unable to recover the proceeds, there are several steps a business needs to take to get to that point. These issues include determining when to recognize a sale for income purposes, when to write-off the possibility of collecting a sale and to what degree the business needs to allow for future uncollectible accounts.

Revenue Recognition Basics

1. For a business to recognize revenue from a transaction, four criteria must be met. There must be evidence that a transaction has occurred, such as a receipt or a contract. The business must have delivered on the promise it made during the transaction. This normally means that it delivered the underlying good or performed the service. The price for that good or service must be known and fixed. Finally, the business must be reasonably confident that it will be able to collect what is owed from the other party.

Accounts Receivable

1. American businesses are required to report their financial activities using the accrual method. Under this method, the business records revenue from a sale when it is earned and all other revenue recognition criteria are met. As a result, a business may be able to recognize the proceeds from a sale before it receives the cash from a customer. These situations require the business to create an asset called accounts receivable. This asset records how much a business is owed from past recorded sales.

Uncollectible Accounts Defined

1. When a business no longer is confident that it will be able to collect what it is owed, the circumstances that allowed the transaction to be recognized for revenue purposes no longer exist. Reasons for a business to assume an account is uncollectible include the other party refuses to pay or the buyer has undergone financial difficulties making it impossible for him to pay.

Allowance for Uncollectible Accounts

1. When a business sells goods on credit, it is likely that it will encounter a few instances where it will be unable to get what is owed. Under U.S. Generally Accepted Accounting Principles (GAAP), a business is required to include a contingency for likely future losses. The possibility of uncollectible accounts is one type of likely loss for which businesses should create an allowance. This allowance proactively decreases a business’s income for the year in anticipation of future uncollectible accounts. The amount of the allowance is determined based on the historical percentage of past receivables that were not collected. For example, assume that historically 1 percent of receivables were determined to be uncollectible. For the current year, the allowance for uncollectibles would be 1 percent of the outstanding accounts receivable.

   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 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:

    

   

    

   Notice that the preceding entry reduces the receivables balance for the item that is 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 it 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 non bank 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. 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.

   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”).

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   With the direct write-off method, 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, and generally result in a fairer balance sheet valuation for outstanding receivables. As will soon be shown, the actual write-off in a subsequent period will generally not impact income.

    

    

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   Did you learn?Be able to apply the direct write-off method.Know the deficiencies of the direct write-off method.Understand the general impact of the allowance methods for uncollectible accounts.Know why an allowance method is preferred over the direct write-off approach.

   Why is it important to collect accounts receivable?

   Accounts receivable is the lifeblood of a business's cash flow. It helps with cash flow management by telling you which clients owe you money and how much. This lets you discern whether your cash account accurately reflects your current financial standing.

   What is an account receivable that Cannot be collected called?

   Accounts uncollectible, also known as uncollectible accounts or bad debts, are credit sales in accounts receivable that are unlikely to be collected from a customer. The term is used in the valuation of accounts receivable on an organization's balance sheet.

   What happens if an accounts receivable is confirmed to be worthless?

   Completely worthless means that the debtor has paid nothing. For both, you can expect that you will not receive any owed money. You can only deduct the amount you charged off on your books.

   What happens when an account becomes uncollectible?

   Uncollectible accounts on a balance sheet are those that the company has deemed uncollectible. That is, it simply recognizes that the income stream from these accounts will be less than the amount owed. It's an accounting rule under FAS 5, which requires companies to write off uncollectible amounts.