Which method of allowing for estimated uncollectible accounts is generally more accurate?

An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable. The allowance, sometimes called a bad debt reserve, represents management’s estimate of the amount of accounts receivable that will not be paid by customers. If actual experience differs, then management adjusts its estimation methodology to bring the reserve more into alignment with actual results.

In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the accuracy of financial reports. The projected bad debt expense is properly matched against the related sale, thereby providing a more accurate view of revenue and expenses for a specific period of time. In addition, this accounting process prevents the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses.

Units should consider using an allowance for doubtful accounts when they are regularly providing goods or services “on credit” and have experience with the collectability of those accounts. The following entry should be done in accordance with your revenue and reporting cycles (recording the expense in the same reporting period as the revenue is earned), but at a minimum, annually.

DR  Bad Debt Expense

CR  Allowance for Doubtful Accounts

When it is determined that an account cannot be collected, the receivable balance should be written off. When the unit maintains an allowance for doubtful accounts, the write-off reduces the outstanding accounts receivable, and is charged against the allowance – do not record bad debt expense again!

DR  Allowance for Doubtful Accounts

CR  Accounts Receivable

For detailed expectations and guidelines related to write offs, see Writing Off Uncollectable Receivables.

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

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.

Which one of the following is the most accurate method for estimating uncollectible accounts?

Which method is used when calculating uncollectible accounts?

What are two ways in which estimating uncollectible accounts improves the accuracy of the financial statements?

Why is the allowance method preferred over?