When you’re running a business, staying on top of your finances is crucial. Good cash management includes estimating how much money you might not be able to collect from customers in the future. Accounting professionals refer to this as the balance for allowance of doubtful accounts or the bad debt reserve. Maintaining accurate balance information ensures you know exactly how much money you have on hand.
What Are Accounts Receivable Doubtful Accounts?
These are customers’ invoices that have been outstanding for an extended period and might not be collected. Common reasons for late payments include customers going out of business or simply not having the money to pay their balances. In some cases, bad business practices or even fraud could lead to doubtful accounts.
What Is an Allowance for Doubtful Accounts Entry?
This journal entry reduces the accounts receivable balance to reflect the amount of money you might not be able to collect. It’s important to remember that doubtful debts still have a slight chance of collection. This small chance differentiates a doubtful account from a bad debt. If it becomes a bad debt, it shows as an expense on the income statement.
The doubtful account entry balances the books and accurately represents a company’s financials. To accomplish this, you create a contra asset account. When recording an allowance for doubtful accounts balance, you make two entries: a debit to the contra asset account and a credit to accounts receivable.
What Role Does the Accrual Accounting Method Play in Tracking Doubtful Debts?
Most small businesses use cash accounting because it is simpler and easier. However, if you extend credit to customers, you might need to consider the accrual accounting method. Here are some examples of businesses that might need to use an accrual accounting system:
- A dentist’s office that allows customers to pay in installments
- A farmer that extends business credit to retail stores and manufacturers
- A repair company that offers net 30 terms to customers
- A restaurant that submits a monthly invoice to the corporations it caters events for
Accrual accounting requires businesses to recognize revenue when earned, not necessarily when paid. Consequently, you record an accounts receivable balance for the customer until they pay their total balance.
What Is the Allowance for Uncollectible Debts Formula?
Businesses can use a few different methods to estimate their allowance for uncollectible debts. No matter which formula for allowance for doubtful accounts you use, you must regularly review and adjust your allowance for uncollectible accounts. Doing this will help ensure that your financial statements are accurate and up-to-date.
Percentage Sales Method
The most common is the percentage of sales method, which takes a percentage of total sales and applies it to the accounts receivable balance.
Formula: Total Sales x Estimated Percentage of Doubtful Accounts
For example, if a company has $100,000 in sales and a bad debt rate of 0.01%, they would estimate their allowance for uncollectible accounts to be $100. Your accounting team arrives at a percentage by reviewing your company’s historical accounts receivable data.
Aging of Accounts Receivable method
This approach looks at how long invoices have been outstanding and applies a percentage to each age group. You then add the results for each period together.
Formula: Estimated Percentage * Period 1 + Estimated Percentage * Period 2
For example, 31 to 60 days old invoices may have a doubtful debt rate of 1%. Meanwhile, 60 to 90 days old invoices may have a doubtful debt rate of 3%. If you have $10,000 outstanding, that works out to $100 for 31 to 60 days and $300 for 60 to 90 days old. These add up to $400 of potential doubtful debt.
Why Is It Important To Know Your Doubtful Account Balance?
Estimating your allowance for doubtful AR can be tricky, but it’s a critical task. If you don’t have an accurate estimate, you could end up overstating or understating your net income, which could have severe consequences for your business.
An understatement of your net income could lead to penalties, while an overstatement could trigger fraud investigations. Maintaining a good handle on your accounts receivable and knowing exactly how much money you can expect to collect is also just good business practice.
How Do Business Owners Know When Doubtful Debts Become Uncollectible?
There is no set answer to this question. Business owners need to review historical data to estimate the point when debt usually becomes uncollectible. As a general rule of thumb, if you have not received payment after several attempts and the customer shows no signs of being able to pay, it’s probably time to write off the debt.
Some business owners determine anything after 60 to 90 days past-due as doubtful debt. Others write anything off after 120 days past-due as bad debt. The accounts receivables team can also use days sales outstanding to set the threshold for doubtful vs. bad debt. In some cases, your customer might make things a lot easier by confirming they cannot pay.
To ensure you can continually improve your estimate, set up a system for tracking payments. This way, you can quickly and easily see which customers are behind on paying invoices and take appropriate action. Accounts receivable automation software is one go-to method for streamlining this task.
Late payments are an unfortunate but common part of doing business. By estimating your doubtful accounts and keeping a close eye on your receivables, you can minimize the impact on your business.
