Accounting for bad debts

There are a couple of methods to estimate bad debt expenses on your books. You should investigate both the Percentage of Credit Sales method and Aging Accounts receivable method to see which is best for your company.

Percentage of Credit Sales

Some firms utilise the percentage of credit sales method to estimate bad debts. This method calculates bad debt expense as a straight percentage of the current year's credit sales. The percentage varies from business to business as it is based on the
prior year's experience with bad debt.

The following equation is used to calculate the estimated bad debt expense:

Current Period Sales X Bad Debt %
= Estimated Bad Debts Expense

For example, if past experience indicates that 0.3% of sales on credit will never be collected, a company using the percentage of sales approach will automatically debit Bad Debts Expense and credits Allowance for Doubtful Accounts for 0.3% of credit sales.If current sales on credit equate to $500,000 that company will estimate its bad debts expense to be $1500 (0.003 x $500,000) and it will record the following journal entry:

Account Name Debit Credit
Bad Debts Expense 1,500

Allowance for Doubtful Accounts

1,500

The percentage of credit sales approach focuses on the income statement and the matching principle - sales revenues of $500,000 are immediately matched with $1500 of bad debts expense. The Allowance for Doubtful Accounts balance is ignored in regular entries (i.e. weekly or monthly entries) however this balance in the allowance account must be reviewed and potentially adjusted on a regular basis (i.e. quarterly) so that the balance sheet will report the correct net realisable value.

Ageing Accounts Receivable

The longer an account remains outstanding, the less likely the debt is to be paid. Therefore many firms maintain an accounts receivable ageing schedule, which categorises each customer's credit purchases by the length of time overdue. Each category's overall balance is multiplied by an estimated percentage of uncollectible debt, with the total of all category calculations providing the estimate of bad debts.

The accounts receivable ageing schedule shown below includes five categories for classifying the age of unpaid credit purchases:

  • current
  • 1-30 days past due
  • 31-60 days past due
  • 61-90 days past due
  • more than 90 days past due.

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The percentage increase in bad debt provisioning correlates directly with the time overdue. In this example, estimated bad debts are $5000. This figure has been calculated based on the following:

1% of current outstanding debts = $800
10% of debts between 1-30 days overdue = $1400
30% of debts between 31-60 days overdue = $900
50% of debts between 61-90 days overdue = $500
70% of debts 90+ days overdue = $1400
Total bad debt provision = $5000

If a firm does not write off its total provision in a given month it must incorporate a credit into the following month's provisions. Conversely, if the bad debt write-off exceeds the provision the debit must be included in the following forecast.

When an account is ultimately determined to be uncollectable, it no longer qualifies as an asset and should be immediately written off your books.

Prudent management of your accounts receivable is vital. The repercussions for errors can prove disastrous for your company. Clearly, choosing the 'right' customers to receive credit - based on accurate, reliable information - is essential.

This article was taken from D&B's Guide to Cash Flow and Credit Risk. Click here to find out more>>

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