Accounting for Doubt as to Collectibility
Learn the accounting principles for managing the uncertainty of receivables to ensure financial statements accurately reflect expected collections.
When a business sells goods or services on credit, it creates an accounts receivable, which is the money owed by the customer. Since there is always a risk that some customers will not pay, the concept of “doubt as to collectibility” requires businesses to estimate and account for the portion of their receivables they do not expect to collect. This ensures the company’s balance sheet presents a more accurate picture of its assets by not overstating the value of its accounts receivable. This practice is an application of the matching principle, a fundamental concept in accrual accounting. The principle dictates that expenses should be recognized in the same accounting period as the revenues they helped generate, properly matching the potential loss with the revenue from that sale.
Estimating Expected Credit Losses
Under current accounting standards, determining the amount of uncollectible receivables is a forward-looking process using the Current Expected Credit Losses (CECL) model. This model requires a company to estimate the full lifetime of expected losses when a receivable is first recorded. This approach means a company must consider not only past events and current conditions but also reasonable and supportable forecasts of future economic conditions.
A customer’s payment history and current financial health are also assessed. For example, a trend of late payments or news of a customer’s financial distress would increase the expected loss estimate. Even if the immediate risk of non-payment seems low, an estimate for expected losses must still be recorded.
Establishing an Allowance for Credit Losses
The standard method for accounting for uncollectible receivables under Generally Accepted Accounting Principles (GAAP) is the allowance method. This involves creating an “Allowance for Credit Losses,” which is a contra-asset account. A contra-asset account is paired with an asset account—in this case, Accounts Receivable—and has an opposite balance to reduce the asset’s net value on the balance sheet. This process ensures the accounts receivable is reported at its net realizable value, the amount the company genuinely expects to collect.
The estimate is recorded with a journal entry that debits Credit Loss Expense and credits Allowance for Credit Losses. The Credit Loss Expense appears on the income statement, reducing the period’s net income, while the allowance account reduces the accounts receivable on the balance sheet.
A common tool used in this estimation is the aging of receivables method. This method categorizes all outstanding receivables by the length of time they have been due. For instance, categories might be 0-30 days, 31-60 days, 61-90 days, and over 90 days. Each category is assigned a different loss rate based on historical data, with the rate increasing as the receivables get older.
The Process of Writing Off an Account
Once a specific customer’s account is determined to be definitively uncollectible, the company must remove it from the books through a process called a write-off. This action is taken only after all reasonable collection efforts have failed and there is no realistic expectation of payment. The write-off does not impact the income statement or the net value of accounts receivable at the time it is recorded. The expense associated with this bad debt was already recognized when the allowance for credit losses was established.
The specific journal entry to write off an account is a debit to the Allowance for Credit Losses and a credit to Accounts Receivable for the specific customer. For example, if a company determines that Customer XYZ’s $1,000 invoice is uncollectible, it would debit Allowance for Credit Losses for $1,000 and credit Accounts Receivable—Customer XYZ for $1,000. This entry reduces both accounts, effectively removing the bad debt from the balance sheet while having a neutral effect on the overall assets reported.
Accounting for Recoveries of Bad Debt
Occasionally, a company receives payment for an account that was previously written off. This event, known as a bad debt recovery, requires a specific two-step accounting process because the original receivable no longer exists on the books.
The first step is to reverse the original write-off entry to reinstate the customer’s account receivable. This is done by debiting Accounts Receivable for the amount recovered and crediting the Allowance for Credit Losses. For instance, if a $500 account that was written off is now being paid, the company would first debit Accounts Receivable for $500 and credit Allowance for Credit Losses for $500.
The second step is to record the cash collection in the standard manner. This involves debiting the Cash account and crediting the now-reinstated Accounts Receivable account. Following the previous example, the company would debit Cash for $500 and credit Accounts Receivable for $500.