## Estimating Allowance for Bad Debts

The risk of non-payment is always present in a credit transaction. Therefore, a credit grantor should realize this risk by establishing an allowance for doubtful accounts. It is an allocation for reduction in the total amount of either sales or accounts receivable that is deemed uncollectable.

The allowance for doubtful accounts is also called bad debt allowance and allowance for bad debt.

The following three methods are generally used for calculating Bad Debt Allowance:

### 1.      Percentage of Credit Sales Method

The following example is used to illustrate this method:

A company has a credit sale of \$100,000 in an accounting period.

Its accounting history estimates that about 1% of its credit sales ends up being uncollectable in an accounting period.

The adjusting entry at the end of the accounting period will be:

Credit Allowance for Bad Debt                   \$1,000

If estimates fail to match actual bad debts, the percentage rate used to estimate bad debts is adjusted in future calculations.

If the company is new and lacks experience, it can calculate its bad debts expense by using an industry norm that is applicable to their line of business. Industry norms can be obtained from third parties like Dun & Bradstreet.

This particular method impacts the Income Statement since it influences the reduction in sales figure of a business. This is the prime reason for it not being a popular method.

### 2.      Percentage of Total Accounts Receivable (AR) Method

Given below is an example to illustrate this method:

A company has a total AR of \$100,000 at the end of an accounting period.

Its accounting history demonstrates that on an average about 3% of its total AR ends up being uncollectable.

The uncollectable balance will be \$3,000 (3% of \$100,000)

The actual write‐off during the just‐completed accounting period may not perfectly match the balance assigned to the allowance for bad debts account at the close of the accounting period. If write‐offs were less than expected, the account will have a credit balance, and if write‐offs were greater than expected, the account will have a debit balance.

The adjusting entry at the end of the accounting period will be:

Credit Allowance for Bad Debt                   \$3,000

(+ or – depending upon the Debit or Credit balance respectively from previous accounting period)

If the company is new and lacks experience, it may calculate its bad debts expense by using an industry average.

This method for allowance for doubtful accounts impacts the company’s Balance Sheet since it reduces the total amount of accounts receivable stated on it. It is listed as a deduction immediately below the reported amount of AR. The allowance is a contra current asset account.

### 3.      Aging Method

The premise of this method is based on an age old fact that “The older the receivable gets, the less likelihood of it being collected”. The common adage: Unlike wine receivables do not get better with age!

In this method of estimating the allowance for doubtful accounts the aging report or aged trial balance (ATB) is used.  Based on the historical experience of a company each aging bucket is assigned a percentage that is deemed uncollectable.

In the following example we have used  1% for the ‘current’ aging bucket; 4% for the 1 to 30days aging bucket, 10% for the 31 to 60 days aging bucket; 30% for the 61 to 90days aging bucket and finally 50% for the over 90 days aging bucket.

ATB May 31st 2018

 Customer Total Balance Current 1 to 30 31 to 60 61 to 90 over 90 A \$          1,900 \$     1,900 B \$          2,000 \$     1,200 \$        800 C \$          1,000 \$        600 \$         400 D \$          2,500 \$     1,800 \$        700 E \$          1,000 \$     1,000 F \$             800 \$      800 G \$          2,800 \$     2,700 \$        100 Remaining Customers AR \$       88,000 \$   71,400 \$  12,500 \$     1,900 \$         800 \$  1,400 Total AR \$    100,000 \$  80,000 \$ 14,100 \$    2,500 \$     1,200 \$  2,200 Doubtful a/c Allowance % 1% 4% 10% 30% 50% Estimated Bad Debts \$         3,074 \$        800 \$       564 \$        250 \$         360 \$  1,100

In this example, the estimated bad debt allowance is \$3,074. The estimate is based on historical records of the company (i.e. its past collection performance).

Net Present Value

Credit Management should also realize that aging of receivable also impacts the 'Net Present Value' of any credit amount, due to the cost of capital involved.

The actual formula for calculating Present Value is:          PV=FV/(1+M)n

Where PV is the resultant net present value to be derived, FV is the given future value, M is the monthly compound equivalent of the annual cost of capital, and n is the time period in months.

The following is a simpler formula that can be used to approximate the present value:

PV = FV - FV(M × n)

Using this simpler formula, if the firm’s annual cost of capital (M) is 12% per annum i.e. 0.12, the monthly cost of capital is .01 (i.e 0.12/12),

Using the simple formula, the present value of a \$100 invoice due in 30 days is:

PV = \$100 - \$100(.01 × 1) = \$99

If the \$100 receivable is expected to be collected in 12 months, the approximate present value would be:

PV = \$100 - \$100(.01 × 12) = \$88

Author: Puru Grover © Credit Guru Inc | CreditGuru.com