An allowance for doubtful accounts is your best guess of the bills your customers won't pay or will pay only partially. You can calculate the allowance subjectively, based on your knowledge of a customer's payment habits or ability to pay. Or you can calculate an allowance that's more formula driven based on the past experience of actual bad debt expense.
Percentage of Credit Sales or Accounts Receivable
The amount you wrote off in past months for doubtful accounts is probably a good predictor of what you might write off in the future. One way to estimate your bad debt allowance is to calculate the actual write-off each month or year over the past several years as a percentage of another related business measure, such as credit sales or accounts receivable. For example, if you wrote off $1,000 in bad debt during a month when your sales were $100,000, the actual bad debt expense was 1 percent of sales. Calculate the actual percentage for each period and then calculate the overall average percentage. Multiply that by the sales or accounts receivable balance to determine your allowance. You can use the same percentage for the whole year, or you might recalculate the percentage on a quarterly basis if the variance between estimated and actual bad debt is larger than you want it to be.
To calculate the amount of the doubtful accounts journal entry, add the current positive or negative account balance to your allowance estimate so the journal entry makes the final account balance the same as your estimate. For example, if the current balance is $5,000 and your allowance estimate is $25,000, the journal entry should adjust the account by $20,000.
Percentage of Receivables by Aging Category
The longer an account is past due, the less likely you are to collect the money you're owed. Rather than using a single percentage of receivables to estimate bad debt allowance, you might want to reserve more for debts that have been past due the longest. Run an accounts receivable aging schedule to review accounts receivable balances that are not yet past due and those that are late by one to 30 days, 31 to 60 days, 61 to 90 days and more than 90 days. Perform an analysis to determine the actual percentage you wrote off over the previous 12 months, or estimate the percentage you might not recover for each group. For example, you might estimate your reserve to be 70 percent for receivables more than 90 days late; 50 percent for 61 to 90 days; 30 percent for 31 to 60 days; 10 percent for one to 30 days; and 1 percent for new charges. Multiply each percentage by the total balance in that category and sum the results to determine the allowance for doubtful accounts.
Risk Analysis by Customer
A more detailed account-by-account analysis might provide the best estimate of an allowance for doubtful accounts. Run a report for every customer account to get its current receivable balance and historical write-off percentage. Then assign a rating to each customer that indicates the risk that you might have to write off a portion of the customer's balance. For example, you might group customers in three to five categories, such as low, medium and high or low, medium-low, medium-high and high. Assign a percentage to each category and multiply that by the category balance to determine the amount of the reserve. Alternatively, you can estimate the reserve for each individual customer and calculate the total amount at risk.
How to Choose a Method
If you don't have many customers, you know your customers well or the bulk of your accounts receivable are from a small number of customers, it's probably worth spending the time to perform a detailed customer-by-customer accounts receivable analysis. If you have many small accounts that are past due and your customers are more anonymous to you, a historical percentage based on sales or receivables will probably provide an acceptable estimate. As you analyze the data, write down your ideas to reduce the amount of bad debt you have. Reducing bad debt can have a significant positive financial impact on your company's performance.