How to Estimate Allowance for Doubtful Accounts
Companies sell products and services for cash or on credit. The accounting entries for credit sales are to credit or increase sales and debit or increase accounts receivable. Doubtful accounts are credit sales that might never be collected. In the allowance method, a portion of your credit sales is set aside in the "allowance for doubtful accounts" reserve account, which is a contra account that reduces the accounts receivable balance. Estimate the doubtful accounts using historical experience and risk classifications, according to the AccountingTools website.
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Instructions
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Use a historical percentage to estimate doubtful accounts. If you have been in business for several years and you have some experience with uncollected accounts, calculate the average bad debts expense as a percentage of sales. For example, if bad debts have been 5, 4, 6, 8 and 3 percent of sales over the past five years, the average is 5.2 percent -- (5 + 4 + 6 + 8 + 3) / 5 = 26 / 5 = 5.2. Therefore, if credit sales are $100,000 in the current period, the doubtful accounts estimate is $5,200 ($100,000 x 0.052).
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Estimate the doubtful accounts based on risk classifications. Group customers by risk of default -- such as low, medium and high risk. Use historical data to assign a bad-debts-expense percentage for each risk category -- for example, 2, 3 and 5 percent for low-risk, medium-risk and high-risk customers, respectively. Multiply the accounts receivable balance in each risk category by its corresponding bad-debts-expense percentage. Add the doubtful account balances for each risk category to get the total doubtful accounts estimate.
For example, if the accounts receivable balances for low-risk, medium-risk and high-risk customers are $4 million, $2 million and $1 million, respectively, the total estimate for doubtful accounts is $190,000 -- ($4 million x 0.02) + ($2 million x 0.03) + ($1 million x 0.05) = $80,000 + $60,000 + $50,000 = $190,000.
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Assess how reasonable your estimate for doubtful accounts is. It should be greater than the sum of your long-overdue accounts. It should also be consistent with your recent bad debt write-off experience and industry trends.
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Make the required accounting entries. To record an initial estimate, debit or increase bad debts expense and credit or increase allowance for doubtful accounts. If parts of this reserve remain uncollected for a long time or if customers default, write off the corresponding amounts. In that case, debit or decrease allowance for doubtful accounts and credit or decrease accounts receivable. If customers are able to rearrange their finances and repay their creditors, record the recovered amounts. To do this, debit accounts receivable and credit allowance for doubtful accounts.
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Tips & Warnings
According to Harold Averkamp of AccountingCoach, generally accepted accounting principles (GAAP) require that companies use the allowance method for financial statement purposes. However, the Internal Revenue Service requires the direct write-off method for tax-filing purposes, where you write off a debt only when you are certain that it will not be collected. The accounting entries are to debit bad debts expense and credit accounts receivable.
