What are uncollectible accounts & how to account for bad debt

Uncollectible accounts, also known as bad debt, represent the portion of accounts receivable that a business no longer expects to collect. Understanding how to identify and account for these uncollectible amounts is crucial for accurate financial reporting. 

This article will explore what uncollectible accounts are and the methods used to account for bad debt.

What are uncollectible accounts receivable? 

Uncollectible accounts, also known as bad debt, represent the portion of accounts receivable that a business no longer expects to collect. Understanding how to identify and account for these uncollectible amounts is crucial for accurate financial statements.

Definition of uncollectible accounts receivable 

Uncollectible accounts receivable balances represent the portion of money owed to a company by its customers for goods or services provided on credit that is unlikely to be repaid. Essentially, they are debts that have gone bad.

Causes of uncollectible accounts

Several factors can contribute to accounts receivable becoming uncollectible:

• Customer bankruptcy: If a customer files for bankruptcy, their ability to repay outstanding credit balances over a reasonable period of time may be severely limited or completely eliminated.
• Financial difficulties: Customers may experience financial hardships due to economic downturns, job losses, or other unforeseen circumstances, making it difficult for them to meet the payment obligations on their debit balance.
• Fraud: In some cases, customers may intentionally deceive a company to obtain goods or services without the intention of paying.
• Disputes: Disputes over the quality of goods or services provided can lead to customers refusing to pay.
• Ineffective collection efforts: A company's own collection efforts may be inadequate, allowing delinquent accounts to age and become uncollectible.

Examples of accounts receivable that cannot be collected

Why should you estimate uncollectible accounts?

Estimating uncollectible accounts, also known as bad debts, is a crucial aspect of financial accounting and reporting. It involves recognizing that not all customers will pay their outstanding invoices, leading to potential losses for the company. This practice is essential for several reasons:

Accurate financial reporting

• Reflects the true value of accounts receivable: Accounts receivable represents the money owed to a company by its customers. However, if a portion of these receivables is unlikely to be collected, the reported value becomes inflated and misleading. Estimating uncollectible balances allows for a more accurate representation of the company's assets.

• Adheres to the matching principle: The matching principle in accounting states that expenses should be recognized in the same period as the revenues they helped generate. By estimating your uncollectible receivables balance, the expense of bad debts is matched with the sales revenue earned in the same period, ensuring a more accurate picture of profitability.

• Complies with the conservatism principle: The conservatism principle suggests that when faced with uncertainty, accountants should err on the side of caution and anticipate potential losses. Estimating uncollectible accounts aligns with this principle by recognizing the possibility of bad debts and preventing an overstatement of assets and income.

Realistic financial health assessment

Provides a clearer picture of financial performance: By accounting for potential losses from uncollectible accounts, a company can present a more realistic picture of its financial health and performance. This information is crucial for internal decision-making and external stakeholders like investors and creditors.

• Aids in credit risk management: Estimating uncollectible accounts encourages companies to assess their credit policies and customer creditworthiness. This helps in identifying high-risk customers and implementing appropriate credit control measures to minimize losses.

Tax implications

• Allows for tax deductions: In many jurisdictions, businesses can claim a tax deduction for bad debts. However, this deduction is often contingent upon the company demonstrating that it has made reasonable efforts to collect the outstanding amounts and has estimated the uncollectible portion.

Overall, estimating uncollectible accounts is not merely a matter of accounting compliance but a fundamental practice that promotes transparency, accuracy, and prudent financial management.

Uncollectible accounts journal entry: How to calculate uncollectible accounts expense

Here's how to calculate uncollectible accounts expense using the Allowance Method and a brief note on the Direct Write-Off Method:

Allowance Method

The allowance method is preferred for accounting for bad debts. It involves estimating and setting aside an allowance for doubtful accounts. There are two main approaches:

Percentage of Sales Method

1. Determine the historical percentage of credit sales that have become uncollectible.
2. Multiply the current period's credit sales by that percentage.

Formula:

Uncollectible Accounts Expense = Credit Sales * Percentage of Uncollectible Sales

Aging of Accounts Receivable Method

1. Categorize accounts receivable by age (e.g., 0-30 days, 31-60 days, 61-90 days, over 90 days).
2. Assign a percentage of uncollectibility to each age group (older accounts have higher percentages).
3. Multiply the balance in each age group by its respective percentage.
4. Sum the results to get the estimated allowance for doubtful accounts.
5. Adjust the allowance account to match this estimated amount. The adjustment is the bad debt expense.

Direct Write-Off Method

The direct write-off method recognizes bad debt expense only when an account is deemed uncollectible. It's simpler but less accurate.

Process:

When an account is determined to be uncollectible, it is directly written off as an expense.

Note: The direct write-off method is generally not accepted for financial reporting under Generally Accepted Accounting Principles (GAAP) because it violates the matching principle.

Uncollectible accounts expense formula

There are two primary methods for calculating uncollectible accounts expense:

Percentage of sales method

This method estimates bad debt expense as a percentage of total credit sales.

Steps:

1. Determine the historical percentage of credit sales that have become uncollectible.
2. Multiply the current period's credit sales by that percentage.

Formula:

Uncollectible Accounts Expense = Credit Sales * Percentage of Uncollectible Sales

Aging of accounts receivable method

This method categorizes accounts receivable by how long they have been outstanding and applies different percentages of uncollectibility to each age category.

Steps:

1. Categorize accounts receivable by age category (e.g., 0-30 days, 31-60 days, 61-90 days, over 90 days).
2. Assign a percentage of uncollectibility to each age category (older accounts have higher percentages).
3. Multiply the balance in each individual category by its respective percentage.
4. Sum the results to get the estimated allowance for doubtful accounts.
5. Adjust the allowance account to match this estimated amount. The adjustment is the bad debt expense.

Allowance for uncollectible accounts formula

How to find allowance for uncollectible accounts. The allowance for potential nonpayment is estimated by aging accounts receivable. This involves categorizing receivables by age, assigning uncollectibility percentages to each age group, and summing the resulting estimated uncollectable accounts.

How to write off uncollectible accounts

Here's an elaborated and significantly expanded explanation of how to write off bad accounts, including the preferred method under GAAP:

Methods for writing off uncollectible accounts

There are two primary methods for accounting for uncollectible accounts:

1. Direct write-off method

• Process: When an account is deemed uncollectible, it is directly written off as an expense on the income statement. This reduces the accounts receivable balance and recognizes the bad debt expense.
• Simplicity: This method is relatively simple and straightforward to apply.
• GAAP compliance: However, the direct write-off method is generally not accepted under Generally Accepted Accounting Principles (GAAP) for financial reporting, except in cases where the amount of bad debt is immaterial.

Matching principle violation: The main reason for its non-compliance with GAAP is that it violates the matching principle, which states that expenses should be recognized in the same period as the revenues they helped generate. The direct write-off method often recognizes uncollectible receivables expense in a different period than the revenue associated with the sale.

2. Allowance method

• Process: This method involves estimating and recognizing bad debt expense in the same period as the related sales revenue.
• Allowance for doubtful accounts: A contra-asset account called "Allowance for Doubtful Accounts" is created on the balance sheet to offset accounts receivable for the current period.
• Estimating bad debts: At the end of each accounting period, an estimate of uncollectible accounts is made based on historical data, aging of receivables, or other relevant factors. This estimate is recorded as bad debt expense on the balance of accounts and increases the Allowance for Doubtful Accounts as part of the accounting process.
• Write-off: When a specific percentage of receivables is identified as uncollectible, it is written off against the Allowance for Doubtful Accounts. This reduces both the accounts receivable and the allowance account.
• GAAP compliance: The allowance method is the preferred method under GAAP because it adheres to the matching principle and provides a more accurate picture of a company's financial position and allows investors to make better informed decisions.

Key considerations

• Materiality: For companies with immaterial amounts of bad debt, the direct write-off method may be acceptable.
• Financial statement impact: The choice of method can impact a company's income statement, balance sheet, and the normal balance on their cash flow statement.
• Internal controls: Companies should have strong internal controls in place to identify and manage uncollectible accounts.

Allowance for uncollectible accounts on balance sheet

Where does allowance for uncollectible accounts go? The allowance for outstanding balances in accounts is presented on the balance sheet as a deduction from accounts receivable. 

This positioning reflects its contra-asset nature—it reduces the value of the associated asset. The net value of accounts receivable (accounts receivable minus the allowance) represents the amount the company realistically expects to collect.

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Key takeaways

1. Uncollectible accounts, or bad debt, are accounts receivable that a business expects not to collect.
2. Estimating uncollectible accounts is crucial for accurate financial reporting, matching expenses to revenues, and complying with accounting principles.
3. The Allowance Method is preferred under GAAP for accounting for uncollectible debts, while the Direct Write-Off Method is less accurate and generally not accepted.
4. Uncollectible accounts expense can be calculated using the Percentage of Sales Method or the Aging of Accounts Receivable Method.
5. The Allowance for Doubtful Accounts is a contra-asset account that reduces the reported value of accounts receivable on the balance sheet.

FAQs

How is accounts receivable affected by the estimate of uncollectible accounts?

The estimate of uncollectible accounts affects accounts receivable by reducing its net realizable value on the balance sheet.

Here's how:

• An "Allowance for Doubtful Accounts" is created, which is a contra-asset account.
• This allowance is subtracted from the total accounts receivable to arrive at the net amount the company expects to collect.
• Therefore, while the gross accounts receivable remains the same, the net realizable value is reduced by the estimated amount of uncollectible accounts.

Is uncollectible accounts a debit or credit?

When recording bad debt expense (uncollectible accounts), you debit the Bad Debt Expense account and credit the Allowance for Doubtful Accounts on your accounting records.

How should you deal with an uncollectible receivable?

The Allowance Method is used to handle uncollectible receivables. First, identify and document uncollectible percentage of accounts. Then, write off the account by debiting the "Allowance for Doubtful Accounts" and crediting "Accounts Receivable." Maintain detailed records and periodically review and adjust the allowance. Consider further collection efforts or debt recovery and understand the tax implications of bad debt write-offs.

What happens when an account becomes uncollectible?

When an account is deemed uncollectible, it is written off. Using the Allowance Method (GAAP preferred), the Allowance for Doubtful Accounts is debited, and Accounts Receivable is credited, adjusting credit balances without impacting the current income statement. The Direct Write-Off Method (less preferred) debits Bad Debts Expense and credits Accounts Receivable.

What is the most common reason an account becomes uncollectible?

The most common reasons an account becomes uncollectible include customer bankruptcy, financial difficulties, fraud, disputes, and ineffective collection efforts.

Is uncollectible accounts bad debt?

Yes, uncollectible accounts are also known as bad debt.