Accounts receivable are a measure of sales already completed whereby the customer pays the amount due at a later time. When the initial sale takes place, revenue is increased and accounts receivable are increased. When the amount is repaid, accounts receivable decreases and cash increases. However, there's always a risk that the customer won't repay his debt. Issues with accounts receivable include when to recognize revenue and initiate an accounts receivable balance for the transaction; how to estimate the amount of receivables that won't be collected; and when to write off an amount due as uncollectible.
A business should recognize revenue when it's earned and realized. Income is earned when the basis of the transaction is completed, which occurs when you either deliver the product you sold or performed the service for which you were contracted. Income is realized when the vendor receives cash or a claim to cash for his product or service. Accounts receivable precludes receiving cash, leaving “a claim to cash” as the sole means of realizing revenue. To establish a legitimate claim for realization purposes, businesses often ask the customer to sign a document promising to pay the amount due.
Allowance for Doubtful Accounts — Definition
When you effectively “loan” a customer the funds to purchase a product, there's always a risk that the debt won't be repaid. Even if you take precautions to ensure that each customer has the ability to repay you, some customers may still default on their obligation. As a result, you need to establish an “allowance for doubtful accounts” to decrease your business’s accounts receivable and income balances. This allowance is an estimate of the receivables default based on your business’s past collection history.
Calculating Allowance for Doubtful Accounts
The allowance is initially expressed as a percentage. For example, you estimate that, historically, 3 percent of all sales on credit aren't collected. Every reporting period, take the overall balance for accounts receivable and multiply it by the allowance percentage to determine the allowance balance. Next, debit, or increase, bad debt expense by the allowance balance, and debit the credit allowance for doubtful accounts by the same amount. This allows you to reflect a better estimate for your income and accounts receivable for the period. The expense and allowance balances decrease income and receivables, which in turn prevents future write-downs on income due to poor collection efforts.
Writing Off Accounts Receivable
When it becomes apparent that a certain customer isn't paying off his outstanding liability, write off that amount. The write-off is no longer an estimate, but it shouldn't affect overall income if you properly recorded your initial allowance. When a receivable is written off, you decrease, or debit, the allowance for doubtful accounts, and decrease, or credit, the accounts receivable balance. This entry enables the accounts receivable balance to reflect the current outstanding amounts due that you expect to collect.
When preparing financial statements, consult with a certified public accountant to ensure that everything is done according to the appropriate accounting guidelines. This article doesn't provide legal advice — it's for educational purposes only. Use of this article doesn't create any attorney-client relationship.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.