Allowance for uncollectible accounts is a method of tracking and writing off the receivables that the clients will not pay. It creates a separate allowance for the revenue that the company suspects it will not receive in the future. The uncollectible accounts are written off from that allowance, rather than the entire balance sheet.
Explanation:
Every business deal comes with a risk, especially if it is performed on credit. A client can go bankrupt, make a fraudulent purchase, or simply take the goods and disappear. The money that the company is supposed to receive for its services is usually recorded in the balance sheets as accounts receivable for that financial period.
However, if the money turns out to be inaccessible, it must be written off as a bad debt expense. It works if the sale is immediate, but if the company operates on credit, it can be a bad practice. If a company makes thousands of deals in 2019 and writes off hundreds of bad debts in 2020, it can become confusing.
Allowance for uncollectible accounts is a more elegant method of accounting for and writing off the money that cannot be received by the company. With every sale on credit, the company estimates the amount of earned revenue that it may not receive. This estimation can be based on previous experience, market averages, or personal judgments.
Then it is recorded in the balance sheet as part of an allowance and detracted from the revenue. If the doubtful accounts turn out to be uncollectible in the future, the loss is written off from the allowance rather than the revenue for the future period. The allowance is recorded as a bad debt expense at the same time as the sale, creating a more accurate balance sheet.
The uncollectible accounts are not written off as additional losses in the future. They are only written off from the existing allowance, which is already seen as a loss. That way the financial risk is managed beforehand, and the possible bad debts are accounted for in the budget by the time they occur.