In prior chapters, the accounting for sales of merchandise or services on account (on unco||ectib|e rereraWes credit) was described and illustrated. A major issue that has not yet been discussed is that some customers will not pay their accounts. That is, some accounts receivable will be uncollectible.
Companies may shift the risk of uncollectible receivables to other companies. For example, some retailers do not accept sales on account, but will only accept cash or credit cards. Such policies shift the risk to the credit card companies.
Companies may also sell their receivables. This is often the case when a company issues its own credit card. For example, Macy’s and JCPenney issue their own credit cards.
Selling receivables is called factoring the receivables. The buyer of the receivables is called a factor. An advantage of factoring is that the company selling its receivables immediately receives cash for operating and other needs. Also, depending on the factoring agreement, some of the risk of uncollectible accounts is shifted to the factor.
Regardless of how careful a company is in granting credit, some credit sales will be uncollectible. The operating expense recorded from uncollectible receivables is called bad debt expense, uncollectible accounts expense, or doubtful accounts expense.
There is no general rule for when an account becomes uncollectible. Some indications that an account may be uncollectible include the following:
- The receivable is past due.
- The customer does not respond to the company’s attempts to collect.
- The customer files for bankruptcy.
- The customer closes its business.
- The company cannot locate the customer.
If a customer doesn’t pay, a company may turn the account over to a collection agency. After the collection agency attempts to collect payment, any remaining balance in the account is considered worthless.
The two methods of accounting for uncollectible receivables are as follows:
- The direct write-off method records bad debt expense only when an account is determined to be worthless.
- The allowance method records bad debt expense by estimating uncollectible accounts at the end of the accounting period.
The direct write-off method is often used by small companies and companies with few receivables.1 Generally accepted accounting principles (GAAP), however, require companies with a large amount of receivables to use the allowance method. As a result, most well- known companies such as General Electric, Pepsi, Intel, and FedEx use the allowance method.
Source: Warren Carl S., Reeve James M., Duchac Jonathan (2013), Corporate Financial Accounting, South-Western College Pub; 12th edition.