Organizations that sell goods and services on account typically set up an account to predict the amount of credit sales that will not collect. This account is generally called the allowance for bad debts or the allowance for uncollectible accounts. There are several methods used to calculate this amount, including the percentage method, which bases the amount on gross credit sales or gross receivables. The purpose of this activity it to record the uncollectible accounts in the period in which they occur. This is a part of the matching principle of accounting.
Determine the average accounts receivable. Calculate the average accounts receivable by adding up the accounts receivable balance at the beginning of the year and the balance at the end of the year. Divide this number by two to find the average balance. For example, the two balances are $70,000 and $100,000. The total of $170,000 is divided by two which results in $85,000.
Review last year's gross credit sales. Look at the prior year's total sales made on account. For example, assume the total sales for the year were $100,000, but only $80,000 were made on account.
Determine the percentage of these accounts that were uncollected. If during that year, $2,000 was written off as uncollectible, divide $2,000 by $80,000 which is 2.5 percent. This means that of all credit sales, 2.5 percent of them were uncollectible.
Multiply average accounts receivable by 2.5 percent. To predict how much will be uncollectible, make this calculation. This calculation bases uncollectible accounts on past experiences of companies. Many companies calculate this percentage each year and average it out to find a more accurate percentage. With this example, multiply the $85,000 times 2.5 percent to get $2,125.
Update the account. To begin the next year, the allowance for bad debts account should begin with a balance of $2,125. If there is a balance of $500 in there already, only the difference must be added. This is done with the following journal entry: debit to bad debts expense for $1,625 and a credit to allowance for bad debts for $1,625.
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