Accounting for uncollectible accounts receivable:

When companies decide to sell products on credit, they usually do not expect to receive full payment from all customers. They do expect, however, to receive enough cash from good customers to make up for the small number of customers whose accounts receivable will not be collected in cash. Two primary purposes of accounting for uncollectible accounts receivable are to properly report in financial statements (1) the dollar amount expected to be collected from credit customers and (2) the cost of selling to some customers who will not pay.
 

Recording uncollectible accounts receivable and the uncollectible accounts expense

At the time credit sales are made, the specific customers who will not pay are unknown. If such customers are known, products would not be sold to them. On the other hand, companies do know that all customers will not pay. Thus, companies who sell on credit must either estimate the dollar amount of accounts receivable that will not be collected or they must wait until the customers who will not pay can be clearly identified. Because it can take several months or even years to identify specific customers who will not pay, it is common practice for companies to estimate uncollectible accounts receivable in the same time period in which they make credit sales.

When credit sales are made, the effect is an increase in resources (assets) and an increase in sources of resources (stockholders’ equity). The specific accounts affected are accounts receivable (debited) and sales (credited). When a company estimates that some of its accounts receivable are uncollectible, in effect it is saying some of its accounts receivable are not resources. Similarly, it is saying its sources of resources are too high because some credit sales will never result in resources, specifically cash. Remember, accounts receivable are not valuable if they do not eventually result in cash. In order to properly account for uncollectible accounts receivable, companies reduce their resources and sources of resources for estimated uncollectible accounts receivable. For example, if a company with $50,000 of January credit sales estimates that 1.5% of such sales will not be collected, it would be affected as follows.

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

- $750

=

 

 

 

 

- $750

 

Resources would be reduced because $750 ($50,000 x .015) of accounts receivable are not expected to be collected. Accounts receivable that do not result in cash are not resources. Sources of resources would be reduced because $750 of the sales recorded earlier as an increase in sources of resources will not result in actual resources.

Since assets increase with debits (and decrease with credits) and debits equal credits, the journal entry to record the $750 uncollectible accounts receivable would be as follows.

Date

Description

Post.
Ref.

Debits

Credits

Jan. 31

Uncollectible Accounts Expense

 

750

 

 

     Allowance for Uncollectible Accounts

 

 

750

 

Uncollectible accounts receivable

 

 

 

 

Uncollectible accounts expense was debited in the above journal entry in order to recognize the expense of selling to some customers who will not pay. Since expenses decrease stockholders equity, and stockholders' equity decreases with debits, uncollectible accounts expense was debited. The allowance for uncollectible accounts was credited because the company's (resources) decreased. Since assets increase with debits, they decrease with credits. The allowance for uncollectible accounts is an asset account. Inasmuch as it usually has a credit balance, as opposed to most assets with debit balances, the allowance for uncollectible accounts is called a contra asset account.

It is important to note why companies use the allowance for uncollectible accounts rather than simply using accounts receivable. At the time uncollectible accounts expense is estimated, accounts receivable can not be decreased immediately because the specific customers who will not pay are not known at that time. Since the specific customers are not known, customer accounts in the accounts receivable subsidiary ledger can not be reduced. Thus, since the accounts receivable subsidiary ledger can not be reduced, accounts receivable in the general ledger can not be reduced or the two ledgers would not be in agreement. Remember the total of all accounts in the accounts receivable subsidiary ledger equals the balance in accounts receivable in the general ledger. Both the accounts receivable subsidiary ledger and the accounts receivable account in the general ledger will be reduced when the company identifies the specific customers who will not pay. Thus, in order to prevent the accounts receivable subsidiary ledger from not agreeing with accounts receivable in the general ledger, estimated uncollectible accounts receivable are recorded in the allowance for uncollectible accounts rather than directly reducing accounts receivable.

When posted to the general ledger, the process of recording uncollectible accounts receivable and the uncollectible accounts expense affects the following accounts.

Accounts Receivable

 

Allowance for
Uncollectible Accounts

 

Uncollectible Accounts Expense

$50,000

 

 

 

$750

 

$750

 

 

The uncollectible accounts expense account shows the company estimates it cost $750 in January to sell to customers who will not pay. The accounts receivable account shows the company's customers owe it $50,000. The allowance for uncollectible accounts shows the company expects its customers to be unable to pay $750 of the $50,000 they owe. Based on accounts receivable and the allowance for uncollectible accounts, the company would predict it could collect $49,250 ($50,000 - $750) from its credit customers. This knowledge of expected cash collections is very important for managers who must plan their cash expenditures. Even though its customers owe it $50,000, management would not plan on spending the full $50,000 because $750 will probably never be received.
 

Estimating uncollectible accounts receivable

As illustrated in the previous section, the estimation of uncollectible accounts receivable results in a journal entry in which uncollectible accounts expense is debited and the allowance for uncollectible accounts is credited. This entry reduces stockholders' equity and assets.

Two different methods commonly used to estimate uncollectible accounts receivable are the percentage of sales method and the accounts receivable aging method. Both methods result in the same accounts being debited and credited, but because the methods are different they usually result in different dollar amounts for the journal entry. The following paragraphs examine both methods.
 
 

Percentage of sales method of estimating uncollectible accounts receivable

The percentage of sales method of estimating uncollectible accounts receivable is based on the relationship between uncollectible accounts receivable and the credit sales that produced them. For example, consider the following recent history of the Nicholas Corporation.

Year

Credit Sales

Accounts Receivable
Not Collected

Percentage
Not Collected

1

$80,000

$1,000

1.25%

2

$90,000

$1,215

1.35%

3

$110,000

$1,705

1.55%

Totals

$280,000

$3,920

1.40%

 

The Nicholas Corporation could have easily obtained the above credit sales information from its general ledger. The total dollar amount of debits to accounts receivable represent credit sales. Similarly, the dollar amount of accounts receivable not collected could have been obtained through an analysis of the company's accounts receivable subsidiary ledger. For example, if the company made $500 credit sales to a customer in year 2 and the company later determined the customer was not going to pay the $500, the $500 would be considered part of the year 2 credit sales that are uncollectible. The above table shows customers owing $1,215 did not pay in year 2 or year 3 and are not expected to pay. Viewed another way, 1.35% ($1,215 / $90,000) of year 2 credit sales were uncollectible.

The Nicholas Corporation could use the above data to estimate its uncollectible accounts receivable in year 4. For example, if the company had January credit sales of $15,000, it could estimate its uncollectible accounts receivable to be $210 ($15,000 x .014). The .014 is the average percentage of uncollectible accounts receivable during year 1 through year 3. On the other hand, since that data suggest uncollectible accounts are increasing, from 1.25% in year 1 to 1.55% in year 3, the company could estimate its uncollectible accounts receivable to be $255 ($15,000 x .017). The .017 reflects an expected increase in uncollectible accounts receivable from the 1.55% experienced in year 3. Regardless of which percentage is used, either percentage would probably result in a reasonable estimate of uncollectible accounts receivable. Using the 1.70% estimate, the Nicholas Corporation would prepare the following journal entry to record uncollectible accounts expense in January.

Date

Description

Post.
Ref.

Debits

Credits

Jan. 31

Uncollectible Accounts Expense

 

255

 

 

     Allowance for Uncollectible Accounts

 

 

255

 

Uncollectible accounts receivable

 

 

 

Practice Exercise

During the last four years, the Christopher Corporation’s credit sales totaled $60,000,000. During the same four years, $2,100,000 of its accounts receivable were determined to be uncollectible.

1. Calculate the Christopher Corporation’s percentage of credit sales during the last four years that were not collected.

Percentage of credit sales not collected = accounts receivable not collected / credit sales

Percentage of credit sales not collected = $2,100,000 / $60,000,000 = .035 = 3.5%.

2. Using the results of part 1, calculate the Christopher Corporation’s January uncollectible accounts expense if January’s credit sales are $4,000,000.

Uncollectible accounts expense = credit sales x percentage of credit sales not collected

Uncollectible accounts expense = $4,000,000 x .035 = $140,000.
 
 

** You now have the background to do text exercise 7.6.

 

 

Previous section

Next section