Table Of Contents
What is an Uncollectible Account?
An uncollectible account is a debt owed to a business but unlikely to be paid by the debtor for any kind of reasons. Accounting for uncollectible accounts aims to accurately reflect the value of accounts receivable on a company's balance sheet.
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They are an important aspect of a company's financial management. By accounting and keeping in check them appropriately, companies can provide accurate and transparent financial statements, which can help them make better decisions and build trust with investors and other stakeholders.
Key Takeaways
- An uncollectible account is an amount of money owed to a business by a customer or client that is unlikely to be paid and, therefore, is considered a loss for the business.
- Two main methods of accounting for uncollectible accounts are the allowance method and the direct write-off method.
- Uncollected debts can negatively impact a company's cash flow, making it difficult to pay bills, make investments, or grow the business. By managing uncollectible accounts, companies can better predict and manage their cash flow.
Uncollectible Account Explained
Uncollectible accounts receivable, also known as bad debts, are customer accounts that are unlikely to be paid in full. When a company sells goods or services on credit, it records the sale as an account receivable. However, not all customers will pay their bills in full, and some may not pay at all. To account for this risk, companies must estimate the amount of uncollectible accounts and record them as an expense in the same period the sale was made.
There are generally two types of uncollectible accounts:
- Specific Uncollectible Accounts: These are individual accounts that a company has determined to be uncollectible due to a customer's inability or unwillingness to pay. This may be due to various factors, such as bankruptcy, fraud, or dispute over the goods or services provided.
- General Uncollectible Accounts: This refers to a portion of a company's accounts receivable deemed uncollectible due to a general economic downturn, a change in the industry, or other factors that may impact a significant number of customer's ability to pay their debts. This is sometimes called a "reserve for bad debts" or "allowance for doubtful accounts."
Journal Entry Methods
There are two main methods for recording uncollectible accounts in the accounting journal:
#1 - Direct Write-Off Method
The direct write-off method involves recording the uncollectible account as an expense when it is determined that the account will not be paid. The journal entry to record the write-off of an uncollectible account is as follows:
- Debit: Bad Debt Expense
- Credit: Accounts Receivable
This reduces the accounts receivable balance by the amount of the uncollectible account and records the expense of the bad debt.
#2 - Allowance Method
The allowance method involves estimating the amount of uncollectible accounts and recording an allowance for that amount as an expense. The journal entry to record the allowance for uncollectible accounts is as follows:
- Debit: Bad Debt Expense
- Credit: Allowance for Doubtful Accounts
The allowance for doubtful accounts is a contra-asset account that lowers the total accounts receivable. When an uncollectible account is identified, the journal entry to write off the account is as follows:
- Debit: Allowance for Doubtful Accounts
- Credit: Accounts Receivable
This reduces the allowance for doubtful accounts by the amount of the uncollectible account and reduces the accounts receivable balance by the same amount.
Examples
Let us look at uncollectible account examples to understand the concept better:
Example #1
Let's say that a company called XYZ Corp provides consulting services to a customer on credit, with payment due within 30 days of the invoice date. The customer, ABC Inc., fails to pay the invoice within the due date despite XYZ Corp's reminders and follow-ups.
After a few months, XYZ Corp determines that the invoice is uncollectible and decides to write off the account as a bad debt. The invoice was $5,000, and XYZ Corp estimates that 10% of its accounts receivable will be uncollectible.
Using the allowance method, XYZ Corp records an allowance for doubtful accounts of $500 ($5,000 x 10%). The journal entry to record the allowance is as follows:
- Debit: Bad Debt Expense $500
- Credit: Allowance for Doubtful Accounts $500
A few more months pass and XYZ Corp determines that the account is uncollectible and writes it off. The journal entry to record the write-off is as follows:
- Debit: Allowance for Doubtful Accounts $500
- Credit: Accounts Receivable $5,000
This reduces the accounts receivable balance by $5,000 and the allowance for doubtful accounts by $500.
Although XYZ Corp has written off the account, it may still pursue legal action or use a collection agency to try to collect the debt from ABC Inc. If the company is eventually able to collect any amount from the customer, it would record it as a recovery of bad debt, and the journal entry would be:
- Debit: Accounts Receivable $x (amount received)
- Credit: Bad Debt Expense $x (amount received)
Example #2
In 2018, Sears Holdings, a retail company, filed for bankruptcy. As part of the bankruptcy proceedings, the company identified a large number of accounts receivable that were deemed uncollectible. The company recorded a bad debt expense of $366 million in its financial statements for the year ended February 3, 2018.
The bad debt expense included uncollectible accounts from customers who had defaulted on their credit card balances, as well as from suppliers who were owed money by the company. The allowance for doubtful accounts was increased to $629 million to reflect the estimated amount of uncollectible accounts at the end of the period.
Sears Holdings' situation is a good example of how uncollectible accounts can arise for various reasons, such as economic conditions, business competition, changing consumer habits, and other factors outside a company's control. In such cases, it's essential for companies to account for bad debts properly, which can help them manage their cash flow and maintain accurate financial records.