Christian Debt Recovery

Accounts Receivable and Uncollectible Accounts

In accounting, Accounts Receivable may not be as straight forward as you may think. From the definition, we know that accounts receivable represents amounts due from customers who have purchased merchandise on credit and who have agreed to pay within a specified period or when billed by the company that they owe. We all know nothing is that simple. For example, what if the customer is late paying, or doesn’t pay at all? Well, the good news is that there are business practices that can help minimize your losses. If the losses are inevitable, then there are adjustments that can be made to your financial statement. These adjustments can show the details of the unfortunate situation. The next couple of paragraphs will walk you through some this information.

Now days it seems like less and less people are carrying cash on them but instead are carrying those simple to use credit cards. Consumers like the thought of buying now and paying later, which means they are buying things on credit. The negative side effect to customers buying on credit is that not all of them are guying to pay. As a business you can check a customer’s credit rating and history all day long, but in the end you are not guaranteed that the customer will pay at all. To deal with this issue, some businesses require down payments so that they are guaranteed at least some income. Another way companies minimize their losses is by increasing their profit margin to counter act those that don’t pay at all. Not all companies do this, but it is most likely common for those that are aggressive and accept high risk customers. The thought process is that the bad debt losses would be offset by the profits coming from greater sales volume. A third way would be to offer discount incentives for those that pay their bill in full within a certain time frame.

If you are an operating business you need to be prepared for these types of situations in which your customers don’t pay the amount they owe to you. You can do this by creating a bad debts expense also known as uncollectible accounts expense, which is the estimated expense recognized in the fiscal period of the sale, representing accounts receivables that are not expected to be collected. You can do this the simple way by estimating a certain percentage that won’t be collected, for example 5% of total sales will go unpaid. Or you can do it a more detailed way by putting your accounts receivable into age categories. This means the longer the account is overdue, the less you can expect to receive. For example 0-30 days 2% will go unpaid, 31-60 days 5% will go unpaid, and so on. A third alternative would be to hire a collection agency, this would come as an expense to your company so you should make the appropriate judgment which option would be best for you.

Not only is it a good idea to try to avoid these types of losses, and estimate them, but there are ways to adjust your financial statement to show these types of losses as well. Some may think it is as simple as reducing your accounts receivable account directly for estimated bad debts, but it’s not that easy. As a business, more often that not, you are uncertain of what customer’s won’t pay. Sometimes you may think that a customer won’t pay the amount due, but in fact they do. A procrastinating customer is quite common. So it is best practice to only write off accounts, as uncollectable, when they are truly identified as such.

The correct way to handle this situation is called a valuation adjustment, which is an adjustment that results in an asset being reported at a net realizable value that is less than cost. This is necessary, because the bad debt expense needs to be recognized and the carrying value of the asset needs to be reduced. You would do this by debiting your Bad Debts Expense on your income statement and crediting your Allowance for Bad Debts on your balance sheet.

In book keeping, this would be considered a contra asset because it is reported as a subtraction from an asset in the balance sheet. Contra assets work opposite that of asset accounts. For example a contra asset increases with credit entries and decreases with debit entries, in which it normally has a credit balance. To show this on the balance sheet you would state your accounts receivable less the allowance for bad debts and be left with net accounts receivable. This allows readers of your financial statement to see the estimated portion of accounts receivable that is expected to be uncollectable.

Running a business isn’t easy. Something as simple as collecting money owed to you might become complicated. The best thing to do is to try to avoid un-paying customers. You can do this by offering up incentives or by running your business accordingly. If that doesn’t work, then make sure you adjust your financial statement correctly to show these types of losses.

Source:

Marshall, David H., Wayne W. McManus, and Daniel F. Viele. Accounting: What the Numbers Mean. Boston: McGraw-Hill Irwin, 2008. Print.

About the Author

My name is Frank Frye. I am currently pursuing my MBA at West Chester University of Pennsylvania.

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