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Uncollectible Accounts in Accounts Receivable

As noted earlier, revenue is recognized at the time a credit sale is made. Recognizing revenue increases a firm’s assets and net income. However, given that some of the receivables may ultimately prove to be uncollectible, assets and net income might be overstated.

Year-End Adjustment - To avoid this possibility, firms make year-end adjustments to recognize that some of their accounts receivable will probably not be collected. Because firms are unlikely to know which particular accounts will prove to be uncollectible, the amount of the adjustment is an estimate.

To illustrate, assume that on December 31, 2000, at the end of its first year of operation the Box Company estimates that $2,400 of its year-end accounts receivable balance of $100,000 will be uncollectible. Keep in mind that this is an overall estimate and that Box is currently unable to identify which particular customers will not fulfill their obligations. Accordingly, the adjustment does not directly reduce accounts receivable. Instead, a negative (contra) asset, allowance for uncollectible accounts, is used.

An expense is also recorded, which is consistent with the matching principle. One cost of generating sales is the receivables that will ultimately prove to be uncollectible. This cost (even though it must be estimated) should be deducted from the sales revenue that gave rise to those receivables. The analysis follows.

The net difference between the balances in accounts receivable and the allowance for uncollectible accounts is net accounts receivable, which is included in total assets on the balance sheet.

Accounts receivable, gross - $100,000
Less allowance for uncollectible accounts - (2,400)
Accounts receivable, net $ - 97,600

Figure 5.3 contains OB’s partial balance sheet. It shows the balance in the allowance account, as well as the net accounts receivable included in total assets.

Figure 5.3 - Partial Balance Sheet

From the information provided, gross accounts receivable on December 31,1997, can be computed as $27,503,000:

Write-Offs - When a firm subsequently ascertains that a particular customer will not pay, that customer’s account is written off. This is done by reducing the balances in accounts receivable and in the allowance for uncollectible accounts. Continuing with the Box Company illustration, assume that on February 11, 2001, Box becomes aware that a customer who owes $450 has just gone out of business and that collection is extremely unlikely. The balances in the accounts receivable and allowance accounts would each be reduced by $450.

Because the balance in accounts receivable is reduced, as is the accompanying contra asset, the write-off has no effect on total assets or expenses. This is proper, because the asset reduction and expense were previously recorded. Box’s net receivable is $97,600, both before and after the write-off.

	Before	After
Accounts receivable, gross	$100,000	$99,550
Less allowance	2,400	1950
Accounts receivable, net	97,600	97,600

The effect of the write-off is depicted graphically in Figure 5.4

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Figure 5.4 - Effect of Write-Offs on Accounts Receivable

Estimation Methods - Firms can estimate the year-end adjustment for uncollectible accounts in several ways. One approach is the aging method. In its simplest form, the aging method classifies the year-end accounts receivable balance into two categories current and past due. Suppose, for example, that a firm’s sales terms are 2/10, net 30. This indicates that all accounts are due within 30 days of sale. On the balance sheet date, accounts that have been outstanding for 30 or fewer days are classified as current. The remainder are classified as past due.

Based on a firm’s past experience, industry norms,and current trends, the firm estimates the percentage of each category that will not be collected. This is the step that requires the most judgment. Also, because older accounts are more likely not to be collected, the past-due category has a higher percentage of uncollectibles than the current category. These percentages are multiplied by each category’s balance to estimate the allowance for uncollectible accounts.

Recall that Box Company estimated its allowance to be $2,400 at the end of 2000. The aging analysis that resulted in this estimate is as follows:

Although other estimation methods can yield different results on a year-to-year basis, over the long run their results will be quite similar.

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