How to Account for Bad Debt with the Percentage of Accounts Receivable Method

Seasoned managers know how to look at accounts receivable and eyeball issues. Accounts over 90 days old when they are typically paid in 30 days are a red flag of trouble. This is where accounts receivable can actually be used to determine a bad debt expense. Specific steps should be taken in attaining an allowance for bad debt using a percentage of the current accounts receivable.

Instructions

Difficulty: Moderate

1. Find the average ending accounts receivable balance and the average write-off for a set period of fiscal years. The number of years that is used for the average will be up to the manager. It usually makes sense to take the last five to six years of data for averages.
2. Divide the average write-off by the average ending accounts receivable balance. For example, if the average write-off for the last five years is $8,000 and the average ending accounts receivable balance is $500,000, then the average percentage is 1.6 percent.
3. Multiply the percentage from step two to the current ending accounts receivable balance. If this year's ending accounts receivable balance is $635,983.00, the allowance for the year is $10,175.73. This is calculated as: 635,938 X .016 = 10,175.73.
4. Set up an account and make an entry based on the calculations. In most organizations, an accountant has the knowledge to do this. The process is repeated annually to keep the most accurate numbers.
5. Use this process to determine if it is still cost effective to offer credit. If the bad debt expense outweighs the cost of extending credit dramatically, management will need to review the process.