As noted earlier, revenue is recognized at the time a credit sale is made. Recognizing revenue increases a firm’s assets and net income. However, given that some of the receivables may ultimately prove to be uncollectible, assets and net income might be overstated.
Year-End Adjustment – To avoid this possibility, firms make year-end adjustments to recognize that some of their accounts receivable will probably not be collected. Because firms are unlikely to know which particular accounts will prove to be uncollectible, the amount of the adjustment is an estimate.
Estimation Methods – Firms can estimate the year-end adjustment for uncollectible accounts in several ways. One approach is the aging method. In its simplest form, the aging method classifies the year-end accounts receivable balance into two categories current and past due. Suppose, for example, that a firm’s sales terms are 2/10, net 30. This indicates that all accounts are due within 30 days of sale. On the balance sheet date, accounts that have been outstanding for 30 or fewer days are classified as current. The remainder are classified as past due.
Write-Offs – When a firm subsequently ascertains that a particular customer will not pay, that customer’s account is written off. This is done by reducing the balances in accounts receivable and in the allowance for uncollectible accounts.