What you will learn to do: Understand accounting for uncollectible accounts
Extending credit to other businesses improves the flow of commerce. Imagine if Home Depot had to wait for tiles to come from a supplier while the accounting department processed all the paperwork. Instead, the purchasing department orders the tiles, the supplier ships the order and sends an invoice, and then the accounting department can take its time processing the paperwork. Meanwhile, thousands of other orders are being sent and fulfilled. It’s efficient and effective. However, every once in a while, a credit customer will go out of business before paying or will declare bankruptcy, or maybe simply refuse to pay and the cost of trying to collect outweighs the benefit.
In any case, with almost certainty, a business that extends credit to customers as an ordinary course of business (called trade receivables) will have to declare some account as uncollectible. At the point of officially giving up on collecting, we accountants will “write off” the account, clearing it from our books and records. It’s just a cost of doing business. If we get too many of those, we tighten up our credit standards. If we aren’t getting any, our credit standards may be too tight—we may be losing legitimate, profitable sales by refusing to serve perfectly fine customers who are just not up to our high standards. Making a profit involves calculated risk.
As accountants, we help management collect and analyze the information it needs to make these credit decisions, but we also have to account for the bad accounts we won’t collect. We booked the revenue and the receivable, and now the receivable is no good.
There are two fundamental methods for handling these uncollectible accounts: the direct write-off method and the allowance method.
The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes.
The allowance method comports better to the accrual basis of accounting by matching bad debt expense to revenue and is the accepted method to record uncollectible accounts for financial accounting purposes.
In addition, sometimes we sell some or all of our receivables to an outside party in order to turn them into immediate cash. We’ll cover that situation in this section as well.