Accounts receivables are classified under current assets on the balance sheet if you expect to collect them within a year or within the operating cycle, whichever is longer. However, unless your company sells goods or services exclusively for cash, some of its receivables inevitably will be uncollectible. That is why it is important to record an allowance for doubtful accounts (also known as ‘bad debts’). These allowances are subjective, especially in uncertain economic times.
Estimating the allowance
When it comes to writing off bad debts for financial reporting purposes, companies generally use one of these two methods:
- The direct write-off method. Some companies record write-offs only when a specific account has been deemed uncollectible, which is called the direct write-off method. Although it is easy and convenient, this method fails to match bad debt expense to the period’s sales. It also may overstate the value of accounts receivable on the balance sheet.
- The allowance method. Many companies turn to the allowance method to properly match revenues and expenses. Here the company estimates uncollectible accounts as a percentage of sales or total outstanding receivables. The allowance shows up as a contra-asset to offset receivables on the balance sheet and as bad debt expense to offset sales on the income statement.
The allowance is based on factors such as the amount of bad debts in prior periods, general economic conditions, and receivables aging. Some companies also include allowances for returns, unearned discounts, and finance charges.
Comparing estimates to collections
How do you assess whether your allowance seems reasonable? An obvious place to begin is the company’s aging schedule. The older a receivable is, the harder it is to collect. If you have a significant percentage of receivables that are older than three months, you might need to consider increasing your allowance.
In addition, auditing standards recommend comparing prior estimates for doubtful accounts with actual write-offs. Each accounting period, the ratio of bad debts expense to actual write-offs should be close to one. If a business has several periods in which the ratio is less than one, the company may be low-balling its estimate and overvaluing receivables.
Exhaustion rate is another metric to consider. This is how long the beginning-of-year allowance will cover actual write-offs. Assume that a company reported an allowance for doubtful accounts of $50,000 as of January 1, 2019, and subsequently writes off $30,000 in 2019 and $40,000 in 2020. The exhaustion rate would be 1.5 years ($50,000 – $30,000 = $20,000 left for 2020; $20,000/$40,000 = 0.5 years).
If your allowance takes several years to deplete, it is probably too high. But if you burn through your allowance in just a couple of months, you might consider increasing the allowance — or taking proactive measures to improve collections.
Contact your CPA if your company’s bad debts are on the rise or if your allowance for doubtful accounts seems out of whack. Armed with years of experience and knowledge of industry best practices, he or she can help assess the situation.