Source: Instrumental “Drops of H2O ( The Filtered Water Treatment )" by J.Lang (feat. Airtone),” Creative Commons, http://ccmixter.org/files/djlang59/37792
[MUSIC PLAYING] Hey everyone, and welcome to today's video on uncollectible accounts. So what is today's video all about? Well, we're going to be talking about uncollectible accounts. And then we're going to look at two methods that are used to record uncollectible accounts. We're going to look at the direct write off method, and then we're also going to look at the allowance method. So we're going to look at both of those.
But let's go ahead and get started with that first bullet point and let's have a general discussion about uncollectible accounts. So what is an uncollectible account? It is accounts receivable that are unpaid and are written off as bad debts expense. So when a business sells goods and services on account, it's inevitable that some customers will not pay. So do we need to recognize and record these uncollectible accounts?
Well, the short answer is yes, we do need to record and recognize these uncollectible accounts. We need to recognize the amounts expected not to be collected from credit customers. So any amounts that we don't expect to collect from customers who made a purchase on account, so who we extended credit to as a business, if there are any amounts that we don't think we'll automatically collect, we need to record those in our financial statements.
And as I mentioned earlier, there are two methods for recording these uncollectible accounts. There's the direct write off method, which we'll talk about a little bit later, and the allowance method. Let's start by looking at that allowance method. Let's discuss that a little bit further. So why use the allowance method? Well, the allowance method is required for financial reporting. So this is the required method. The allowance method allows us to match our bad debts expense with the period that the event occurred.
So it allows us to match that expense with the revenue transaction that took place, that we're recording these bad debts for. So what adjustment? There is an adjustment that needs to be made, we need to make an adjusting entry that is made at the end of the period. So we make our adjustments for our allowance at the end of the period. What does the journal entry look like for that adjustment? Well we're going to have a debit to bad debts expense and a credit to allowance for bad debts, or allowance for uncollectible accounts.
The key there is that an allowance account is going to be credited. And this allowance account is a contra asset account, meaning it reduces the accounts receivable. And it's recorded separately from accounts receivable so that we can maintain and track our accounts receivable and know exactly what's going on in there, and then we track our allowance separately. So how would we go about determining uncollectible accounts?
Well, a business or a company creates their own estimate of the amount to be uncollectible. They can use information about industry standards, the past experience they've had with uncollectible accounts, and any other logical estimations that management can come up with. And some common methods used to calculate the uncollectible accounts would be percentage of net credit sales, aging receivables, and percentage of receivables.
So we've discussed methods for recording, we've looked at the allowance method, now we need to talk about that direct write off method. Let's do that now. So the direct write off method. Why use the direct write off method? Well generally, the direct write off method is not used in practice. OK, so it's not used in practice, and if you'll remember, the allowance method is required for financial reporting. So what's the adjustment if we were to use the direct write off method?
We would still make an adjusting entry at the end of the period. But what would that entry look like? It's going to be slightly different than the entry under our allowance method. Again, we would debit bad debts expense, but this time, our credit would be directly to accounts receivable. So we're still reducing accounts receivable, but it's a direct reduction of our accounts receivable. So under the direct write off method, we're removing our accounts receivable, which can create errors or additional work if accounts are later collected that we had written off, and it really reduces the ability of a business to track outstanding accounts and follow up for collection.
So now determining uncollectible accounts within the direct write off method is very similar to the allowance method. A company or business creates their own estimates. Industry standards, using past experience, and any other logical explanations. And also in the direct write off method, there might be a review of specific accounts for specific accounts that get written off. So now, we've discussed our methods for recording, we've discussed our allowance method, and now we've discussed our direct write off method. So now we can summarize what we talked about today.
In a nutshell, today was all about uncollectible accounts. Uncollectible accounts is accounts receivable that are unpaid and are written off as bad debts expense. We looked at the allowance method, and then we finished up with the direct write off method. I hope everybody enjoyed this video and I hope to see you next time.
Accounts receivable that are unpaid and are written off as Bad Debts Expense.