Uncollectible Accounts Receivable

Unfortunately, not all customers that make purchases on credit will pay companies the money owed. The matching principle requires companies align revenues with expenses in the current accounting period. Therefore, companies must adjust accounts receivable for the anticipated write off expense associated with uncollectible accounts.

Companies will normally use the methods below to adjust for uncollectible accounts:

• Direct Write-off Method: records bad debt expense in the same accounting period the company determines it will not collect the money owed. The direct write-off method does not require the company to perform estimates, since it will be based on factual reports.

This method is used for federal income tax purposes, which allows companies to expense bad debts after write off occurs. Since the company may attempt to collect money owed for several months, the direct write-off method violates the matching principle, and should not be used when valuing accounts receivable in financial statements.

• Allowance Method: records an estimate of bad debt expense in the same accounting period as the sale. The allowance method aligns with two important accounting guidelines. It follows the matching principle, which states revenues generated in an accounting period need to be matched with the expenses incurred in that same accounting period. It also abides by the conservatism constraint, which states when in doubt, report information that does not overstate income or assets or does not understate expenses or liabilities.

Accounts receivable is known as a control account. This means the total of all individual accounts found in the subsidiary ledger must equal the total balance in accounts receivable. The allowance method uses an estimate of uncollectible expense, also known as bad debts expense, and does not predict which individual accounts will be written off. For this reason, the adjustment to accounts receivable is made using the contra asset account allowance for doubtful accounts, which is sometimes referred to as the allowance for bad debts. This lets companies to display accounts receivable in what is known as "net realizable value" on the balance sheet.

Company A's Q1 ending balance of accounts receivable was 3,867,000. Using the percentage of sales method, Company A determined bad debt expense in the current quarter would be 16,350 (2% of credit sales). The current balance in the allowance for doubtful accounts was $60,990. The journal entry for bad debts expense would be:

The balance in the allowance for doubtful accounts would now be:

= $60,990 + $16,350, or $77,340

The net realizable value of accounts receivable, as shown on Company A's balance sheet, would be:

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