The amount of uncollectible accounts receivable must be estimated in order to create an allowance for doubtful accounts. This estimate can be derived from the aged accounts receivable report, or by using a percentage of sales. Both approaches are described next. This estimate is used in an accrual-basis business where reserves are set up in contra accounts to be paired with and offset various asset accounts.
Derivation from an Aging Analysis
A common estimation method is based on the aged accounts receivable report. This report categorizes unpaid customer invoices by time bucket. Each time bucket is usually in 30-day increments, so the 31-60 day bucket, the 61-90 day bucket, and the 90+ day bucket show those invoices with increasing probabilities of nonpayment. The accountant assigns a larger percentage of assumed nonpayment probability to each of these time buckets, such as 5% to the balance in the 31-60 day bucket, 20% to the 61-90 day bucket, and 40% to the 90+ day bucket. These percentages are based on the historical experience of the firm in obtaining payments from each of these classifications. The totals of estimated unpaid amounts for each time bucket are then added together to arrive at the total amount of estimated uncollectible receivables. This approach works best when receivables include a small number of relatively large invoices.
Derivation from Total Sales
A simpler approach is to assume that a percentage of total credit sales will not be collected. This percentage, which is based on historical experience, is multiplied by total credit sales. Thus, if the historical experience is a 0.5% bad debt rate, then this amount is applied to total credit sales. This approach is not as refined as a derivation from the aged receivables report, but can be adequate when sales are comprised of many small invoices.
Accounting for Uncollectible Receivables
No matter which method is used, the resulting estimate is added to the allowance for doubtful accounts by debiting the bad debt expense account and crediting the allowance for doubtful accounts.
When a company sells goods and/or provides services on account [on credit] using the accrual basis or method of accounting, the amount of the sales or service revenues is reported on the income statement and the related accounts receivable is reported on the balance sheet [until the receivables are collected]. Unfortunately, some customers may not pay the amount owed to the company. In order to not overstate the company's profits and current assets, the following is required:
- The income statement must report the estimated uncollectible accounts expense [bad debts expense, doubtful accounts expense] that occurred during the accounting period
- The balance sheet must report in the contra asset account Allowance for Uncollectible Accounts [or Allowance for Doubtful Accounts] the estimated amount of the accounts receivable that will not be collected
Examples of Estimating Uncollectible Accounts Receivable
Two common ways of estimating the amount of uncollectible receivables are:
- Preparing an aging of accounts receivable to identify the potentially uncollectible accounts. The aging lists every customer's balance and then sorts each customer's balance according to the amount of time since the sale[s] occurred. The most recent sales are assumed to be fully collectible, but receivables that are past their due dates are past due. The more days they are past due, the greater the likelihood the receivable will not be collected in full. Based on a detailed review of the past due accounts, a reasonable estimate is recorded as uncollectible. For example, if a company's accounts receivable is $90,000 and it is estimated that $6,000 will not be collected, the balance in the account Allowance for Uncollectible Accounts must be a credit balance of $6,000. This will communicate that the net amount that will be turning to cash is $94,000. If the balance in the Allowance for Uncollectible Accounts is presently a credit balance of $1,500, the entry needed is a $4,500 credit to Allowance for Uncollectible Accounts, and a $4,500 debit to Uncollectible Accounts Expense.
- Estimating the amount of uncollectible accounts by simply recording a percentage of the credit sales that occur in each accounting period. For example, if a company and its industry have the experience of 0.2% of credit sales being uncollectible, the company might enter 0.2% of each period's credit sales as a debit to Uncollectible Account Expense and a credit to Allowance for Uncollectible Accounts. For example, if the company has $100,000 of credit sales in May, it will record an entry to debit Uncollectible Accounts Expense for $200 [$100,000 X 0.002] and credit Allowance for Uncollectible Accounts for $200. [Periodically, the company should also prepare an aging to be certain that the credit balance in the Allowance account is reasonable. If needed, an adjustment should be made to the balance.]