Your customers may not always pay for your goods or services immediately, and some may never pay at all.Most businesses sell their products to their customers on credit, which means that the buyer receives the product and an invoice which asks them to pay the purchase price within a set time period.Customers may never pay, or may only pay part of the amount owed to you, if this model is used.Because they're a necessary evil of doing business, sellers should maintain an allowance for the default of these so-called "doubtful" accounts.Learning how to account for doubtful debts is a matter of recording the allowance in the right place.
Step 1: The accounts receivable documents should be gathered.
It is unlikely that a company will be able to collect all of the money owed if they sell goods or services on credit.To account for this, begin with your business's historical and current accounts receivable records.These should detail the business's various customers and their order amounts, along with whether or not those customers have paid in the past.
Step 2: Determine which method to use.
The allowance for doubtful accounts is not a direct expense measure, but an estimate of expected future defaults.Unlike your power bill or the cost of printer paper, you won't know what your doubtful debt expense will be.All customer orders will be recorded as revenues when you report your expenses.You have to estimate the total amount of sales orders that won't be paid.There are several ways to estimate this expense, including using a percentage of total sales, individual risk analysis, or a combination of the two.Depending on the makeup of your customer base, which one is the best choice for your business.The estimation process for each method is explained in the following steps.
Step 3: You can use a percentage of total sales.
For companies with a relatively large number of smaller accounts that only buy small amounts of product, the best and easiest option is to estimate the allowance as a percentage of sales.Determine a reasonable percentage of sales by examining historical records.Look over your records to find out when your sales accounts went bad.It's a good idea to look over the past five years to see your total sales and the total value of your accounts.The debt accounted for the average percentage of total sales.You can divide the value of accounts by the total sales figure.You will get a percentage of the total sales that were not paid.The percentage is applied to the sales figure.The company will adjust the allowance for doubtful accounts to 3% of the total sales for the current accounting period if a certain amount of debts historically went delinquent.
Step 4: Risk analysis is used.
Use an individualized risk analysis for each customer if your company deals with a small number of clients.The categories are based on the historical risk of the accounts.Some clients are considered high risk, while others are low risk or medium risk.The doubtful accounts percentage is assigned to each category and reflects the likeliness of customers failing to pay their accounts.An estimated allowance for doubtful accounts can be arrived at by taking these percentages and dividing them by total sales.This method can be more artistic than scientific.You cannot assign a historical risk rate to a new customer.You can either use a historical percentage of sales for all accounts or use your own judgement of the customer.A customer that has historically let their purchases go unfilled may become more reliable with time.They might be able to raise their risk rating higher than a historical analysis suggests.For a more specific example, imagine a customer that has historically paid their debts every time or almost every times, perhaps only faltering once during hard times.Classify sales by this customer, and others like them, as "low risk" and assign them a very low bad debt percentage like 0.5%If you want to get the bad debt expense for low risk accounts, you have to take the total sales in these accounts.
Step 5: You can use a combined analysis.
If your company has a large amount of clients, but also a few large clients that make up a disproportionate share of total sales, consider combining the two methods.The risk analysis method can be used for larger clients and the percentage of sales method for smaller clients.Separating total sales for large and small clients is more accurate than using a historical sales percentage across the board.You have three clients that make up 60 percent of your sales.All of these clients pay for your products on time.If you assign these clients a low bad debt allowance percentage, you can use the total sales of these customers to get an estimate.Smaller customers that only order a few products at a time make up 40% of your business.To create a historical unpaid debt percentage for these customers, you would examine total debts and total sales to them.
Step 6: A receivables aging schedule can be created.
A more complex process uses historical data to determine the likelihood of payment based on how many days past due an invoice is.Decide on an average point at which late accounts tend to become uncollectible and estimate your doubtful accounts by age.Current accounts are categorized as either current or not due yet.Figuring out bad debt percentages using this process is complicated and best left to account software, which can calculate this information accurately and quickly.
Step 7: A sale on credit can be recorded in the journal.
Recording the sale in the general journal is necessary for accounting for doubtful debts.Imagine that your company sells $2000 of services to a customer.To record the journal entry, you will have to deduct accounts receivable and credit service revenue.
Step 8: The journal entry can be used to create the doubtful account allowance.
Uncollectible accounts are assumed to be 2 percent of total service revenue.The allowance needs to be somewhere between 0.02 and 40.To record the journal entry and establish the allowance account, you have to deduct bad debt expenses and credit allowance for doubtful accounts.Net realizable receivables are what's called when you subtract your allowance for doubtful accounts from Accounts Receivable.This is the total amount of receivables that you expect to collect.The matching principle dictates how to record the expense.Even if this customer pays in full, record the expense to match its revenue.
Step 9: The allowance account's balance needs to be adjusted.
Make another journal entry to increase the allowance account if the company records another $10,000 in service sales.Credit Allowance for Doubtful Accounts is for $200.The allowance account's balance has increased.The additional revenue doubtful account percentage should be adjusted based on which customer or risk category it is coming from.
Step 10: To recognize an uncollectible account, record the journal entry.
A journal entry is needed when an individual account is uncollectible.Imagine that a customer's account balance has been deemed uncollectible.To write off the account, you have to deduct the allowance for doubtful accounts and credit accounts receivable.The allowance account balance is used to cover the drop in receivables.
Step 11: The entry should be reversed upon payment.
Sometimes a payment can be paid in full or in part.This can be a result of action taken by a collections agency.In this case, reverse the entry by crediting the allowance for doubtful accounts for the same amount as the recovered amount.