Uncollectable Accounts and Bad Debt Expense
Uncollectable Accounts and Bad Debt Expense
Matching principle dictates that all expenses incurred in generating revenue must be deducted from that revenue earned in the same period. This reduces mismatch in recognizing and recording transactions that occur when revenues are generated and the costs incurred as a result of this revenue generation during that reporting period. Matching principal along with accrual accounting practices enables a more accurate evaluation on the profitability and performance of an entity.
Often times an entity allows customers to purchase merchandise or services on credit. When a customer makes a purchase on credit, the accrual principle dictates that the revenue is to be recorded in the accounting period when the purchase was made. Most entities extend some amount of credit through invoicing. When a customer agrees to pay for goods received or services at a later point in time, they are often sent an invoice that they have to pay by the date specified. This date is either 30, 60 or 90 days from the purchase date.
When the purchase is made, an entry is made to reflect the revenue earned. Since the company doesn't receive cash at the point of sale, it would instead attribute the amount of the sale to an Asset account called Accounts Receivable. Once the customer remits payment, the amount of that payment is removed from the Accounts Receivable account and attributed to the Cash or Checking account. Accounts Receivable is also a control account that must have the same balance as the combined balance of every individual account in the accounts receivable ledger.
Whenever an entity extends credit to its customers, it assumes the risk that some of its customers will default on their payments. These are known as bad debts and are categorized as bad debt expense. One of the important ways in which matching principle can be applied to Accounts Receivable is to match the bad debt expense to the same period when the sales revenue was recorded.
An entity often times estimates the bad debts based on a method called percentage of credit sales method. It is based on a simplified assumption that a percentage of all credit sales will not be collectable by the end of that reporting period.
Another way of estimating bad debts is to analyze Accounts Receivables and categorize them into the duration each of the accounts is overdue. Accounts that are more than 60 days overdue will warranty immediate action and accounts that are more than 90 days may be good candidates to be assigned to debt collection agencies. This method is called aging of receivables method.
At this point, the entity only knows the approximate amount of accounts that are not collectable but does not know which specific accounts will have to be written off. One can often wonder whether the uncollectable amount can be deducted directly from Accounts Receivable. This cannot be the case because Accounts Receivable is a control account that must have the same balance as the combined balance of every individual credit. Since the specific customer accounts that will become uncollectible are not yet known, a contra-asset account named Allowance for Bad Debts is subtracted from accounts receivable to show the net realizable value of Accounts Receivable on the balance sheet. This contra asset account has a normal credit balance instead of debit balance because it is a deduction to Accounts Receivable. The Allowance of Bad Debts account communicates to the financial statement readers that an estimated portion of the total amount of accounts receivable is expected to become uncollectable.
In the mortgage and financial industry, the necessity for a bank to maintain sufficient reserves to withstand bad loans is crucial. For example, if a bank makes 1,000 loans during a quarter and it knows from statistical experience that 10 of those loans will not be repaid, or will become slow-paying loans. Rather than waiting for the credit loss to occur, the bank uses its best judgment to account for those losses through a provision for loan losses. This reserve provides a cushion if and when customers don't repay their loans. Without this cushion, there's a chance the bank could be caught with little or no capital.
Whenever a bank fails to collect on a loan, the reserve is depleted by that loan amount which is called a charge-off. The loan loss reserve is a contra-asset account on a bank's balance sheet. Each quarter the loan loss reserve rises by the amount of the loan loss provision and reduced by the level of net charge-offs. Every charge-off causes the reserve to shrink. If this reserve gets too low, the bank replenishes the reserve with the provision for loan losses. Over time, provisions for loan losses should be about equal to charge-offs, ensuring that the reserve doesn't get too low. If the bank is making many high-risk loans, it must increase its reserves. When the estimates for bad loans are incorrect, the balance sheet fails to reflect the correct picture and this could lead to false sense of wellbeing of the bank or financial institution.
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