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Uncollectible Receivables

Receivables may become uncollectible for several reasons, including a company's insolvency, or a company's refusal to make payment when required.

Companies that sell goods or services on credit, lend monies, or report other receivables run the risk of not collecting those receivables. Customers or borrowers may experience financial difficulty or become insolvent, or a customer may be dissatisfied with a good or service provided and refuse to make payment on that good or service. As a result, a company must evaluate the collectibility of its receivables each reporting period and ensure those receivables are appropriately presented on the balance sheet.

Undoubtedly, there are receivables that a company will not collect or expects it will not collect. These uncollected or uncollectible receivables result in an expense to the company. This expense, known as bad debt expense, sometimes referred to as uncollectible account expense, is an operating expense that is viewed as a normal and necessary risk of making sales on account. Accounting practice provides for two methods a company can use to account for its bad debt expense.

The first method, the direct write-off method, only reports bad debt expense when a particular account is actually determined to be uncollectible. In other words bad debt expense presents only actual losses rather than estimated losses from uncollectible accounts. At the time of this determination, the related receivable is also removed from the books.

The other method for accounting for bad debts is the allowance method. Under this method, at the end of each reporting period, a company estimates accounts it believes may become uncollectible, and it reports bad debt expense based on that estimate. The accumulated estimates of bad debts are reported in a contra asset account, an account having the opposite normal balance of the related account. That account is called the allowance for doubtful accounts, which is a contra account to accounts receivable that reports the accumulated amount of accounts receivable a company estimates it will not collect. It has the effect of reducing receivables to net realizable value. Net realizable value represents the future cash a company expects to receive from those receivables.