how to estimate the allowance for doubtful accounts
two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected the sales method applies a flat percentage to the total dollar amount of sales for the period for example based on previous experience a company may expect that 3 of net sales are not collectible if the total net sales for the period is 100 000 the company establishes an allowance for doubtful accounts for 3 000 while simultaneously reporting 3 000 in bad debt expense if the following accounting period results in net sales of 80 000 an additional 2 400 is reported in the allowance for doubtful accounts and 2 400 is recorded in the second period in bad debt expense the aggregate balance in the allowance for doubtful accounts after these two periods is 5 400 the second method of estimating the allowance for doubtful accounts is the aging method all outstanding accounts receivable are grouped by age and specific percentages are applied to each group the aggregate of all group results is the estimated uncollectible amount for example a company has 70 000 of accounts receivable less than 30 days outstanding and 30 000 of accounts receivable more than 30 days outstanding based on previous experience 1 of accounts receivable less than 30 days old will be uncollectible and 4 of those accounts receivable at least 30 days old will be uncollectible therefore the company will report an allowance of 1 900 70 000 1 30 000 4 if the next accounting period results in an estimated allowance of 2 500 based on outstanding accounts receivable only 600 2 500 1 900 will be the adjusting entry amount some companies may classify different types of debt or different types of vendors using risk classifications for example a start up customer may be considered a high risk while an established long tenured customer may be a low risk in this example the company often assigns a percentage to each classification of debt then it aggregates all receivables in each grouping calculates each group by the percentage and records an allowance equal to the aggregate of all products if a company has a history of recording or tracking bad debt it can use the historical percentage of bad debt if it feels that historical measurement relates to its current debt for example a company may know that its 10 year average of bad debt is 2 4 therefore it can assign this fixed percentage to its total accounts receivable balance since more often than not it will approximately be close to this amount the company must be aware of outliers or special circumstances that may have unfairly impacted that 2 4 calculation a pareto analysis is a risk measurement approach that states that a majority of activity is often concentrated among a small amount of accounts in many different aspects of business a rough estimation is that 80 of account receivable balances are made up of a small concentration i e 20 of vendors this 80 20 ratio is used throughout business though the pareto analysis can not be used on its own it can be used to weigh accounts receivable estimates differently for example a company may assign a heavier weight to the clients that make up a larger balance of accounts receivable due to conservatism assume a company has 100 clients and believes there are 11 accounts that may go uncollected instead of applying percentages or weights it may simply aggregate the account balance for all 11 customers and use that figure as the allowance amount companies often have a specific method of identifying the companies that it wants to include and the companies it wants to exclude management may disclose its method of estimating the allowance for doubtful accounts in its notes to the financial statements 