Uncollectible Accounts, the Allowance Method & Bad Debt

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  • 0:01 Uncollectable Accounts
  • 0:46 Accounting for…
  • 3:51 Examples
  • 5:14 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

Do you think that every customer that opens a credit account will pay off their balance completely? In the real world, not every customer does. In this lesson, you are going to learn what uncollectible accounts are and how to account for them.

Uncollectible Accounts

Imagine that you're a business owner. In your store, you have two ways to pay for merchandise. A customer can pay cash or he can open a credit account and make monthly payments to you until the merchandise is paid for. Do you think that every single person that you extend credit to is going to pay? Unfortunately, not every customer will do that. There are a few that will leave you hanging.

This type of customer account falls into a category known as uncollectible accounts. Uncollectible accounts are accounts that can't be collected because of the inability of a customer to pay the account or the lack of interest in paying the account. But just as with any other type of account, uncollectible accounts must be recorded in order to ensure accurate financial reports at the end of an accounting period.

Accounting for Uncollectible Accounts

How exactly are uncollectible accounts accounted for? The most common way, and the way that we will focus on in this lesson, is by using a combination of two accounts - the allowance for doubtful accounts and the bad debt expense. I'm going to discuss the allowance for doubtful accounts first.

The allowance for doubtful accounts is an offset of the accounts receivable account and is used to reduce the balance in the accounts receivable of a company. But, what is the accounts receivable of a company? The accounts receivable is the account that's used to record credit sales, or money owed, to a company.

Each time that a credit sale is made, the balance in the account receivable account increases. The balance represents the amount of money that the company expects to receive from its credit customers. So, when a customer doesn't pay, then obviously, the balance in that customer account won't be collected.

Here is where the allowance method comes into play. Since the business owner doesn't know who will or will not pay, then they must estimate a reasonable dollar amount that won't be collected in order to keep their accounting records as accurate as possible. If the company has been in operation for a little while, then they can reasonably decide the percentage of past accounts that were uncollectible. If not, then the rule of thumb is to use the industry average to calculate what dollar amount of uncollectible accounts can be reasonably estimated for each accounting period. Keep in mind, however, that the dollar amount calculated is simply an estimate of a future bad debt.

For example, let's say that the business you own is a children's clothing store. This is your first year of operation, so you really don't know how many of your credit customers will actually pay you or not. The industry average of uncollectible accounts in the children's clothing industry is 1.5%. The total amount of credit sales that you had for the second quarter was $11,200. Of those sales, according to the industry average, you believe that 1.5% will become uncollectible. So, that gives you a total dollar amount of expected uncollectible accounts of $168.

Now let's say that you've been open for three years, and you know that historically your percentage of uncollectible accounts is .89%. If the credit sales for the current period are $14,128, then the amount of these credit sales that are considered uncollectible is $125.74.

So, now that you know how to calculate the dollar amount of expected uncollectible accounts using the allowance method, let's talk about how this amount is recorded in the accounting records. Any transaction that is recorded in the accounting records of a company requires the use of two accounts - one is debited and one is credited. We already know one account that's used to record information about uncollectible accounts - it's the allowance for doubtful accounts. The account that's used in partnership with the allowance for doubtful accounts is called the bad debt expense account.

The bad debt expense account is the account that shows the amount of uncollectible accounts receivable that have occurred in a given accounting period. So, why is an expense account used? Because funds that are expected to be collected but end up as uncollectible become expenses to the company.

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