What if a customer does not pay?

When a company concludes that some specific customers are not going to pay, those customers' accounts receivable should no longer be considered resources. Remember, accounts receivable are resources (assets) primarily because they will be converted into cash. If conversion into cash seems impossible, the accounts receivable are worthless and should be eliminated from the company's resources. For example, if on February 15 the Nicholas Corporation concluded one of its customers owing $125 would never be able to pay, the company would eliminate the account receivable through the following journal entry.

Date

Description

Post.
Ref.

Debits

Credits

Feb. 15

Allowance for Uncollectible Accounts

 

125

 

 

      Accounts Receivable

 

 

125

 

Uncollectible accounts receivable

 

 

 

 

Accounts receivable was credited in the above journal entry because accounts receivable are assets and assets decrease with credits. The allowance for uncollectible accounts was debited in the above journal entry because this account represents an estimate of accounts receivable that will not be collected. Once it is known that a customer will not pay and that customer's account receivable is eliminated through the above credit to accounts receivable, the balance in the allowance for uncollectible accounts should be reduced to reflect the estimated dollar amount of other customers' accounts receivable that will not be collected. In other words, the balance in the allowance for uncollectible accounts should relate only to customers who still owe the company. The allowance for uncollectible accounts was reduced through the above debit.

Since accounts receivable and the allowance for uncollectible accounts are both part of a company's resources, the above journal entry has the following effect on the company's resources and sources of resources.

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

+ $125
allowance for uncollectible accounts

- $125
accounts receivable

 

 

 

 

 

 

 

The company's resources increase when the contra asset allowance for uncollectible accounts is reduced. Similarly, resources decrease when accounts receivable are reduced. Thus, the elimination of a customer's account receivable does not effect the company's total resources or sources of resources. Although this may seem strange at first, remember resources and sources of resources were reduced previously when the company estimated its uncollectible accounts expense and recorded the debit to uncollectible accounts expense and the credit to the allowance for uncollectible accounts.

In addition to posting to the general ledger the journal entry to record the customerís failure to pay, the detail would be posted to the accounts receivable subsidiary ledger. These records must be updated for the customerís failure to pay in case the customer request additional products in the future.
 

Payment received from uncollectible accounts receivable

On rare occasions, cash payments are received from customers whose accounts receivable had been eliminated because they had been considered uncollectible. When payments are received, it is quite obvious that the accounts receivable should not have been eliminated as uncollectible. Thus, the effects of journal entries in which the accounts receivable were eliminated should be cancelled. Since the journal entry to eliminate accounts receivable was a debit to the allowance for uncollectible accounts and a credit to accounts receivable, its effects can be cancelled by a debit to accounts receivable and a credit to the allowance for uncollectible accounts. Once this entry is prepared, it would be posted to the general ledger and the detail would be posted to the accounts receivable subsidiary ledger, restoring the customers' accounts to their balances before the accounts were eliminated.

Once the general ledger accounts receivable and the subsidiary ledger customers' accounts have been restated to their proper balances, the cash received from customers would be recorded as a debit to cash and a credit to accounts receivable. This entry would be posted to the general ledger while the detail would be posted to the accounts receivable subsidiary ledger.

As an example of the accounting for a payment received from a customer whose account was previously judged to be uncollectible, consider the Nicholas Corporation's $200 cash received from the Sullivan Company on March 2. Assume also that in January the Nicholas Corporation had eliminated the Sullivan Company's $200 account receivable by debiting the allowance for uncollectible accounts for $200 and crediting accounts receivable for $200. On March 2 the Nicholas Corporation would prepare the following two journal entries.

Date

Description

Post.
Ref.

Debits

Credits

Mar. 2

Accounts Receivable

 

200

 

 

     Allowance for Uncollectible Accounts

 

 

200

 

Sullivan Co. accounts receivable

 

 

 

 

 

 

 

 

Mar. 2

Cash

 

200

 

 

     Accounts Receivable

 

 

200

 

Collection from Sullivan Co.

 

 

 

 

The first journal entry above eliminates the effects of the January transaction in which the Sullivan Company accounts receivable was judged to be uncollectible. The second journal entry simply records the cash receipt and the corresponding reduction in accounts receivable. Both entries would be posted to the general ledger and the detail would be posted to the accounts receivable subsidiary ledger. As one result of this process, the Sullivan Company account in the accounts receivable subsidiary ledger would show the company did pay for its purchases. If the above information had not been put into the Nicholas Corporation's accounts receivable subsidiary ledger, it would appear that the Sullivan Company had failed to pay $200 it owed.
 

Summary of accounting for accounts receivable

Accounts receivable are created by companies providing products or services to customers in return for their promises of future payment. This process results in an increase in resources (accounts receivable) and an increase in sources of resources (sales or fees revenue). Because some customers will not pay, there is a cost involved in providing such products or services on credit. This cost is called the uncollectible accounts expense. The uncollectible accounts expense must be estimated because the specific customers who will not pay are not known at the time products or services are provided to them. Similar to other expenses, however, the uncollectible accounts expense results in a decrease in resources (through an increase in the allowance for uncollectible accounts contra asset) and a decrease in sources of resources (stockholders' equity is reduced through an increase in uncollectible accounts expense). All other accounts receivable events discussed in this chapter do not result in changes in total resources or sources of resources. The events discussed simply change the composition of resources, usually from accounts receivable to cash.
 
 

** You now have the background to do text exercise 7.9.

 

 

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