Which method for estimating uncollectible accounts is calculated based on a percent of the accounts receivable balance?

An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible. However, the actual payment behavior of customers may differ substantially from the estimate.

• The allowance for doubtful accounts is a contra account that records the percentage of receivables expected to be uncollectible.
• The allowance is established in the same accounting period as the original sale, with an offset to bad debt expense.
• The percentage of sales method and the accounts receivable aging method are the two most common ways to estimate uncollectible accounts.

Regardless of company policies and procedures for credit collections, the risk of the failure to receive payment is always present in a transaction utilizing credit. Thus, a company is required to realize this risk through the establishment of the allowance for doubtful accounts and offsetting bad debt expense. In accordance with the matching principle of accounting, this ensures that expenses related to the sale are recorded in the same accounting period as the revenue is earned. The allowance for doubtful accounts also helps companies more accurately estimate the actual value of their account receivables.

Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity does not know for certain which exact receivables will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure. The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.

Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected.

The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense.

If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.

The second method of estimating the allowance for doubtful accounts is the aging method. All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group. The aggregate of all group results is the estimated uncollectible amount.

For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and 4% of those accounts receivable at least 30 days old will be uncollectible.

Therefore, the company will report an allowance of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 - $1,900) will be the adjusting entry amount.

One of the hardest things to accept when running a business is that clients aren’t always going to pay their bills. Regardless of whether your business offers a product or service, you are likely to encounter at least one (if not a few) clients that will just not pay their debts.

Uncollectable accounts can be financially damaging for businesses in a lot of ways, making it difficult to manage cash flow, to accurately forecast revenue, and to plan for the future.

In addition to practicing good billing, invoicing, and follow-up strategies to encourage and ensure prompt and on-time payments, it’s also important for businesses to properly account for bad debts in their budgets. While it’s not a fun prospect to think about, estimating the allowance for uncollectible accounts is absolutely essential to keeping your business running smoothly.

Why Estimating Allowance for Uncollectible Accounts Matters

Budgeting and planning for bad debts or doubtful accounts is also known as an allowance for uncollectible accounts. This is the area underneath your accounts receivable balance on your balance sheet.

Estimating for uncollectible accounts is necessary if you want to ensure solid and proper financial management and accurate financial statements. Not only is this best practice for giving yourself a clearer picture of your business’ finances, but it is also incredibly important for potential lenders, investors, and/ or stakeholders.

3 Methods to Estimating Bad Debts and Allowance for Uncollectible Accounts

There are three ways to estimate bad debts, and that is to compare the amount of bad debts to the percentage of sales, to the percentage of accounts receivables, and to the age of accounts receivables.

1. Percentage of Sales – This method estimates the amount of bad debt expense a company will incur based on the amount of sales it receives. For example, if a business makes $100,000 in sales and estimates that 5 percent of sales is bad debts, then this would mean that approximately $5,000 should be added to the allowance for doubtful accounts. Essentially, this is the average amount of money that is written off at the end of the year.

2. Percentage of Accounts Receivables – This method is like the sales method; however, the base of calculation is the current amount of accounts receivable the business has accumulated. The final amount indicates the balance for doubtful accounts.

For example, let’s say a company estimates that 5 percent of accounts receivables are deemed uncollectible and the accounts receivables balance is $100,000. By following this method, the balance of allowance for doubtful accounts should be $5,000.

3. Aging of Accounts Receivable – This method is a bit more precise when compared with the other two estimation methods. The age of accounts receivables ultimately determines the likelihood a client will make a payment. For example, the longer an invoice is open, the less likely the client will pay it.

This allowance method focuses on reporting uncollectible payments in the same period in which sales incur. The process of matching invoice payments with related sales and revenue is a solid method for estimating and properly accounting for uncollectible receivables.

These methods can help accurately estimate the allowance for doubtful accounts and will work well if your sales typically make up a small amount of revenue over a large pool of clients.

On the other hand, if you have a small pool of clients that make up a large portion of your revenue, then it may be a good idea to identify the likelihood of default for each client.

When All Else Fails…

Some businesses may find that it is impossible to estimate uncollectible accounts at the end of a period. In these cases, it is best to simply use the direct write-off method, which means that no entries are recorded until a client officially defaults on a payment.

Although there is no standard percentage to be used in estimating bad debts, your company’s historical financial information is the best resource to use to help forecast future financial activity and growth. Take some time to review your past financial statements with your accountant and evaluate the relationship between sales, receivables balances, and bad debts.

For example, if your business made $500,000 in revenue and the total amount of bad debts that were written off totaled $5,000, and these figures were accurate in previous years, then it is safe to assume that bad debts make up approximately 1 percent of sales.

Accurately Estimating Allowance for Uncollectible Accounts Can Help Your Business Thrive

Although thinking about clients defaulting on their payments is enough to keep business owners up at night, it’s best to have a clear financial picture of the business from day one. 

Rather than watching money seemingly fly out of your bank account without accurate figures or data to show you why, it’s best to get your financial statements in order from the beginning. Create room in your budget to allow for doubtful accounts. This will not only keep you up-to-date on where your business stands but also to ensure a healthier financial future for your business.