Estimating Bad Debts | Financial Accounting (2024)

Estimating uncollectible accounts Accountants use two basic methods to estimate uncollectible accounts for a period. The first method—percentage-of-sales method—focuses on the income statement and the relationship of uncollectible accounts to sales. The second method—percentage-of-receivables method—focuses on the balance sheet and the relationship of the allowance for uncollectible accounts to accounts receivable.

Percentage-of-sales method The percentage-of-sales method estimates uncollectible accounts from the credit sales of a given period. In theory, the method is based on a percentage of prior years’ actual uncollectible accounts to prior years’ credit sales. When cash sales are small or make up a fairly constant percentage of total sales, firms base the calculation on total net sales. Since at least one of these conditions is usually met, companies commonly use total net sales rather than credit sales. The formula to determine the amount of the ending estimated bad debtsentry is:

Bad Debt Expense = Net sales (total or credit) x Percentage estimated as uncollectible

To illustrate, assume that Rankin Company’s estimates uncollectible accounts at 1% of total net sales. Total net sales for the yearwere $500,000; receivables at year-end were$100,000; and the Allowance for Doubtful Accounts had a zero balance. Rankin would make the following adjusting entry at year end:

Rankin reports Bad Debt Expense on the income statement. It reports the accounts receivable less the allowance among current assets in the balance sheet as follows:

On the income statement, Rankin would match thebad debt expense against sales revenues in the period. We would classify this expense as a selling expense since it is a normal consequence of selling on credit.

The Allowance forDoubtfulAccounts account can have either a debit or credit balance before the year-end adjustment. Under the percentage-of-sales method, the company ignores any existing balance in the allowance when calculating the amount of the year-end adjustment (except that the allowance account must have a credit balance after adjustment).

For example, assume Rankin’s allowance account had a $300 credit balance before adjustment. The adjusting entry would still be for$5,000. However, the balance sheet would show $100,000 accounts receivable less a $5,300 allowance fordoubtful accounts, resulting in net receivables of $94,700. On the income statement, Bad Debt Expense would still be 1%of total net sales, or $5,000.

In applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts that resulted from the previous year’s sales. If the percentage rate is still valid, the company makes no change. However, if the situation has changed significantly, the company increases or decreases the percentage rate to reflect the changed condition. For example, in periods of recession and high unemployment, a firm may increase the percentage rate to reflect the customers’ decreased ability to pay. However, if the company adopts a more stringent credit policy, it may have to decrease the percentage rate because the company would expect fewer uncollectible accounts.

Percentage-of-receivables method The percentage-of-receivables method estimates uncollectible accounts by determining the desired size of the Allowance for Uncollectible Accounts. Rankin would multiply the ending balance in Accounts Receivable by a rate (or rates) based on its uncollectible accounts experience. In the percentage-of-receivables method, the company may use either an overall rate or a different rate for each age category of receivables.

To calculate the adjusting entry amount of the entry for bad debt expense under the percentage-of-receivables method using an overall rate, Rankin would use:

Bad Debt Expense = (Accounts receivable ending balance x percentage estimated as uncollectible) – Existing credit balance in allowance fordoubtful accounts or + existing debit balance in allowance fordoubtful accounts

Using the same information as before, Rankin makes an estimate of uncollectible accounts at the end of the year. The balance of accounts receivable is$100,000, and the allowance account has no balance. If Rankin estimates that 6% of the receivables will be uncollectible, the adjusting entry would be:

Accounts Receivable would be reported on the balance sheet as (notice how the allowance for doubtful accounts equals 6% of accounts receivable):

If Rankin had a $300 credit balance in the allowance account before adjustment, the entry would be the same, except that the amount of the entry would be$ 5,700. The difference in amounts arises because management wants the allowance account to contain a credit balance equal to 6% of the outstanding receivables when presenting the two accounts on the balance sheet. The calculation of the necessary adjustment is [($100,000 x 6%)- $300] =$ 5,700. Thus, under the percentage-of-receivables method, firms consider any existing balance in the allowance account when adjusting for uncollectible accounts and must remove any previous amounts in the allowance for doubtful accounts. The year end adjusting entry would be:

Accounts Receivable would be reported on the balance sheet as (notice how the allowance for doubtful accounts still equals 6% of accounts receivable):

As another example, suppose that Rankin had a $300 debit balance in the allowance account before adjustment. Then, a credit of $6,300 would be necessary to bad debt expense to get the balance to the required$6,000 credit balance. The calculation of the necessary adjustment is [($ 100,000 x 6%) +$300] =$6,300. The year end adjusting entry would be:

No matter what the pre-adjustment allowance account balance is, when using the percentage-of-receivables method, Rankin adjusts the Allowance forDoubtful Accounts so that it has an ending credit balance of $6,000—equal to 6% of its$100,000 in Accounts Receivable. The desired$6,000 ending credit balance in the Allowance for Doubtful Accounts serves as a “target” in making the adjustment.

So far, we have used one uncollectibility rate for all accounts receivable, regardless of their age. However, some companies use a different percentage for each age category of accounts receivable. When accountants decide to use a different rate for each age category of receivables, they prepare an aging schedule. An aging schedule classifies accounts receivable according to how long they have been outstanding and uses a different uncollectibility percentage rate for each age category. Companies base these percentages on experience. In Exhibit 1, the aging schedule shows that the older the receivable, the less likely the company is to collect it.

Exhibit 1: Accounts receivable aging schedule

Classifying accounts receivable according to age often gives the company a better basis for estimating the total amount of uncollectible accounts. For example, based on experience, a company can expect only 1% of the accounts not yet due (sales made less than 30 days before the end of the accounting period) to be uncollectible. At the other extreme, a company can expect 50% of all accounts over 90 days past due to be uncollectible. For each age category, the firm multiplies the accounts receivable by the percentage estimated as uncollectible to find the estimated amount uncollectible.

The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the desired credit balance (the target) in the Allowance for Uncollectible Accounts.

Since the aging schedule approach is an alternative under the percentage-of-receivables method, the balance in the allowance account before adjustment affects the year-end adjusting entry amount recorded for uncollectible accounts. For example, the schedule in Exhibit 1 shows that$24,400 is needed as the ending credit balance in the allowance account. If the allowance account has a $5,000 credit balance before adjustment, the adjustment would be for $19,400 calculated as $24,400 estimated amount uncollectible from Exhibit 1 – 5,000 existing credit balance in the allowance account. The entry would be:

Accounts Receivable would be reported on the balance sheet as (notice how the allowance for doubtful accounts equals the estimated amount uncollectible from Exhibit 1):

The information in an aging schedule also is useful to management for other purposes. Analysis of collection patterns of accounts receivable may suggest the need for changes in credit policies or for added financing. For example, if the age of many customer balances has increased to 61-90 days past due, collection efforts may have to be strengthened. Or, the company may have to find other sources of cash to pay its debts within the discount period. Preparation of an aging schedule may also help identify certain accounts that should be written off as uncollectible.