The adjusting entry for uncollectible accounts is essential in order to match bad debts with the sales of the period that gave rise to the bad debts. Sometimes in business, it may be the following year before one may discover that a sale made in the current year will not be collectible. Thus, it is ideal that you recognize the bad-debt expense in the period in which the sale took place and the account receivable was generated, rather than in the period in which you determine that the customer was unable to pay.
This is because if you wait to record the bad-debt expense in the year following the sale, you would be violating the matching principle. Hence, in order to adhere to the matching principle, the allowance method is used wherein the uncollectible account expense for the period is matched against the sales for that period. This means that you have to estimate the uncollectible account expense in the period of the sale.
An estimate is needed because it is impossible to be certain which accounts outstanding in particular at the end of the year will become uncollectible in the next year. Hence, this estimate is usually recorded at year-end through an adjusting entry for uncollectible accounts. In this article, we will discuss adjusting entries for uncollectible accounts and how to account for uncollectible accounts receivable.
Related: Year-end Adjusting Entry- Examples and Types
Understanding uncollectible accounts
Uncollectible accounts refer to those receivables (full amount due) that a business or company is unable to collect from the customer. Before reporting an account receivable in the books, a business must have a reasonable basis for assuming that it can collect the outstanding obligation. Hence, for an account to become uncollectible, there must be a shift in the underlying circumstances of the customer such as bankruptcy, failure to pay when the amount is due, or a souring of the customer-vendor relationship.
When a business makes credit sales, there are possibilities that it will encounter a few challenges where it will be unable to get what the customer owes. As a result, a business is required under U.S. Generally Accepted Accounting Principles (GAAP) to include a contingency for possible future losses. The likelihood of uncollectible accounts is one type of possible loss for which businesses should create an allowance that proactively reduces the income of the business for the year, in anticipation of future uncollectible accounts.
The amount of the allowance for uncollectible accounts is determined based on the historical percentage of past accounts receivables that were not collected. For instance, let’s say historically 1 percent of receivables were determined to be uncollectible. This means that for the current year, the allowance for uncollectible accounts would be 1 percent of the outstanding accounts receivable. When preparing a balance sheet, the dollar balance in the Allowance for uncollectible accounts is netted against the dollar balance of gross accounts receivable. This net amount represents the estimate of the net realizable value of the business’s receivables.
The Allowance for Uncollectible Accounts, therefore, serves as a contra-asset account on the balance sheet with a credit balance. Other names for this account are Allowance for Doubtful Accounts and Allowance for Bad Debts. It is listed on the balance sheet with a negative value that is meant to offset the value of accounts receivable.
See also: Adjusting entries examples- Adjustment of journal entries examples
How to record adjusting entry for uncollectible accounts
When recording uncollectible accounts, either the direct write-off method or the allowance method is used. That is, when an account is officially considered uncollectible, a business must make one of two entries in order to record the adjusting entry for uncollectible accounts. If a reserve account is created, the adjusting entry for uncollectible accounts requires a debit to the allowance for uncollectible accounts and a credit to the accounts receivable account.
This means that, in order to journalize the adjusting entry for uncollectible accounts, you make a debit to the allowance for uncollectible accounts and a credit to the accounts receivable account. The reserve created is a contra-asset account with a negative value that is expected to offset the accounts receivable value on the balance sheet. Hence, the adjusting entry adjusts the accounts receivable balance in order to show the amount that is currently collectible.
However, on the other hand, if no reserve is created, the adjusting entry for uncollectible accounts would be to credit the accounts receivable and create a journal entry for uncollectible accounts in order to debit the bad debt expense and write off the uncollectible account. This adjusting entry would decrease the accounts receivable and the income of the business for the year.
Furthermore, if a customer later pays its debt and the business is able to recover funds from an accounts receivable account that it wrote off, it would need to reverse the recorded adjusting entry for uncollectible accounts that were entered when the account was written off. If a reserve was created, in order to reverse the adjusting entry for uncollectible accounts, you would first debit accounts receivable and credit the allowance for uncollectible accounts for the amount of money received for the receivable. Then, you make a debit to the cash account and credit accounts receivable for the amount of cash received.
On the other hand, if there is no reserve, in order to reverse the adjusting entry for uncollectible accounts, you would have to credit uncollectible accounts expense and debit accounts receivable for the amount received and then debit cash and credit accounts receivable for the same amount.
How to record adjusting entry for uncollectible accounts using the allowance method
The allowance method is an estimate of the amount of accounts receivable (from credit sales) that the business expects will be uncollectible. This is recorded as an adjusting entry in the books at the end of each accounting period in order for the business to remain in compliance with financial reporting requirements. That is, the adjusting entry for allowance for uncollectible accounts would be:
| Account | Debit | Credit |
|---|---|---|
| Allowance for Uncollectible Accounts | $00 | |
| Accounts receivable | $00 |
If a business were to recover funds from an accounts receivable account that it wrote off, it would have to reverse the adjusting entry for uncollectible accounts, by making the following entries:
| Account | Debit | Credit |
|---|---|---|
| Accounts receivable | $00 | |
| Allowance for Uncollectible Accounts | $00 |
| Account | Debit | Credit |
|---|---|---|
| Cash | $00 | |
| Accounts receivable | $00 |
How to record adjusting entry for uncollectible accounts using the direct write-off method
The direct write-off method, on the other hand, is not an estimate; rather it is a realized bad debt. It is the writing-off of the bad debt as soon as the business has determined that a certain account is uncollectible. That is the adjusting entry for uncollectible accounts receivable would be:
| Account | Debit | Credit |
|---|---|---|
| Bad Debts Expense | $00 | |
| Accounts Receivable | $00 |
However, if the business later recovers the funds from an accounts receivable account that it wrote off using the direct write-off method, it would have to reverse the adjusting entry for uncollectible accounts receivable, by making the following entries:
| Account | Debit | Credit |
|---|---|---|
| Accounts receivable | $00 | |
| Bad Debts Expense | $00 |
| Account | Debit | Credit |
|---|---|---|
| Cash | $00 | |
| Accounts receivable | $00 |
Read also: How to do adjusting entries with examples
Adjusting entry for uncollectible accounts examples
In order to understand adjusting entries for uncollectible accounts, let’s look at an example using the direct write-off method and the allowance method.
Assume ABC Company often give their customers credit and provides an invoice that must be paid within 15, 30, or even 60 days. When this company makes a credit sale, it records the sale in the accounts receivable account. Let’s say ABC company sells $1,550 worth of goods due within 30 days, the entry to record this will be:
| Date | Account | Debit | Credit |
|---|---|---|---|
| April 1 | Accounts Receivable | $1,550 | |
| Sales Revenue | $1,550 |
Unfortunately, 30 days have passed and the customer is yet to pay. ABC Company, therefore, recognizes the sale as uncollectible and will have to record the adjusting entry for uncollectible accounts. If using the direct write-off method, the adjusting entry for uncollectible accounts would be:
| Date | Account | Debit | Credit |
|---|---|---|---|
| August 31 | Bad Debts Expense | $1,550 | |
| Accounts Receivable | $1,550 |
On the other hand, if the Allowance method is being used, the adjusting entry for uncollectible accounts will be:
| Date | Account | Debit | Credit |
|---|---|---|---|
| August 31 | Allowance for Uncollectible Accounts | $1,550 | |
| Accounts Receivable | $1,550 |
Obotu has 2+years of professional experience in the business and finance sector. Her expertise lies in marketing, economics, finance, biology, and literature. She enjoys writing in these fields to educate and share her wealth of knowledge and experience.
