In the accrual world of accounting, GAAP says that expenses should be recorded in the period in which the related revenues are earned. When it comes to your customers or clients paying their bills, it might not always happen and depending on the terms of the arrangement, it could be months before you are sure that they are not going to pay up. When this happens, a bad debt expense is created, but these bad debts related to the revenue that was recognized in previous periods. Therefore, in accrual accounting, we create an estimate for an allowance for doubtful accounts. The allowance for doubtful accounts is a contra-asset account related to the receivable asset account. It is used to reduce the gross accounts receivable balance to the net realizable value or amount that management expects to be collectible. Since this is an estimate, there are a few different ways management calculates this balance. The following are three of the basic methods for estimating your allowance account:
- Percentage of total accounts receivable
- The percentage of credit sales
For the percentage of total accounts receivable method, you would calculate the allowance as a percentage of your receivable balance. This would then be adjusted at the end of each reporting period. For example, let’s say that your receivable balance at year-end was $100,000 and that on average 2% of the accounts receivable balance becomes uncollectible. Therefore, the allowance balance should be $2,000 at the end of the reporting period.
Similarly, with the percentage of credit sales method, you would calculate the allowance as a percentage of your credit sales. However, this method fails to consider any of the existing amounts in the receivable balance that may be leftover from the prior period.
The aging method takes a little more work; however, it may be a more accurate estimate. This method requires using an aging schedule, which categorizes each credit sale into buckets by the length of time that the amount is outstanding. We see that the longer an item is unpaid the greater the chance that the amount is uncollectible. In this method you would assign a percentage to each bucket for the amount you believe may become uncollectible and then multiply the balance in each bucket by the assigned percentage. For example, in the 1 to 30-day bucket you could assign 1% of that balance as potentially uncollectible, in the 31 to 60-day bucket 20%, in the 61 to 90-day bucket 60%, and finally, in the 90+ day bucket you may estimate that 80% would be uncollectible. This is just an example and not indicative of the percentages you should use.
When evaluating your method for calculating allowances it is important to remember that no one method is perfect and that all these calculations rely on your judgment. These methods and their underlying assumptions should be evaluated periodically to ensure that the allowance accounts reflect what is expected to take place. Furthermore, these methods are useful when you have a large customer base making up your accounts receivable. In instances where your customer base is smaller, the best approach to evaluating your allowance for doubtful accounts is to evaluate the collectability of aged accounts receivable on a customer-by-customer basis.
Have questions? Our audit + accounting professionals help clients in a variety of industries including construction, dealerships, restaurants, technology, and more. Are you ready to chat with an experienced CPA? Contact a Henry+Horne professional.