In prior chapters, we described and illustrated the accounting for transactions involving sales of merchandise or services on credit. A major issue that we have not yet discussed is that some customers will not pay their accounts. That is, some accounts receivable will be uncollectible.
Many retail businesses 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 to other companies. This is often the case when a company issues its own credit card. For example, Macy’s, Sears, and JCPenney issue their own credit cards. Selling receivables is called factoring the receivables, and
the buyer of the receivables is called a factor. An advantage of factoring is that the company selling its receivables receives immediate cash for operating and other needs. In addition, depending upon the factoring agreement, some of the risk of uncollectible accounts may be shifted to the factor.
Regardless of the care used in granting credit and the collection procedures used, a part of the credit sales will not be collectible. The operating expense recorded from uncollectible receivables is called bad debt expense, uncollectible accounts expense, or doubtful accounts expense.
When does an account or a note become uncollectible? There is no general rule for determining when an account is uncollectible. Once a receivable is past due, a company should first notify the customer and try to collect the account. If after repeated attempts the customer doesn’t pay, the company may turn the account over to a collection agency. After the collection agency attempts collection, any remaining balance in the account is considered worthless. One of the most significant indications of partial
or complete uncollectibility occurs when the debtor goes into bankruptcy. Other indications include the closing of the customer’s business and an inability to locate or contact the customer.
There are two methods of accounting for receivables that appear to be uncollectible: the direct write-off method and the allowance method. The direct write-off method records bad debt expense only when an account is judged to be worthless. The allowance method records bad debt expense by estimating uncollectible accounts at the end of the accounting period.
In the next sections of this chapter, we describe and illustrate the accounting for bad debt expense using the direct write-off method and the allowance method. We begin by describing and illustrating the direct write-off method since it is simpler and easier to understand. The direct write-off method is used by smaller companies and by companies with few receivables.1 Generally accepted accounting principles, however, require companies with a large amount of receivables to use the allowance method.