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An allowance for uncollectible accounts is an entry on an accounting statement to reduce the total accounts receivable by the number of accounts the company will probably not be able to collect on, writing off bad debt. This provides a more realistic picture of a company's finances by avoiding a situation where it overstates the amount of accounts receivable to make it look like more money is coming in. Accountants can use several methods to come up with this figure, and they must be consistent about how they calculate it to maintain the integrity of financial statements.
One way to handle uncollectible accounts is to consider them accounts receivable until it becomes evident they will never pay out. The problem with this method is that companies can overstate the income they expect to receive. With an allowance for uncollectible accounts, the company determines the average number of accounts that enter default and records it on the balance sheet as a “contra asset” to offset the accounts receivable. This allows companies to anticipate write-downs of bad debt by accounting for them as early as possible.
A mortgage lender, for example, expects a certain percentage of loans to enter default. It determines this allowance every month, based on the number of new mortgages it issues to write down the accounts receivable immediately, rather than waiting for those accounts to enter default. This allows the company to provide a more accurate picture of its financial health.
Once it becomes evident that individual accounts are in default and the company cannot expect repayment, it can write them down, classifying them officially as uncollectible accounts. This allows the company to claim an expense in the form of bad debt, allowing it to reduce its tax liability. It can take months of negotiating over a delinquent account to make the decision to classify it as uncollectible. Thanks to the allowance for uncollectible accounts that the company uses in its financial statements, the default is already accounted for in the company's accounts receivable declarations.
If a company underestimates this figure, it can create problems. The company may be reluctant to write down some delinquent accounts, fearing that these declarations will push its financial statements into the red. It could also be accused of inflating its financial health to deceive shareholders and other investors, a potentially serious charge if people can prove the company knew its estimates were off and chose to keep using them.