(Last Updated On: November 1, 2018)
When a company produces products or services for customers and issues invoices for payment of those products or services, it is reasonable to assume that many of those invoices will not be paid. Unpaid receivables like these become and will need to be addressed.
Learning how to calculate can be handled a couple of different ways. The first is the method which simply credits the potential in . Since is part of the , it does not affect the . Instead, a is made under the for category, and a is issued to Accounts Receivable.
The for helps to estimate the a company believes it will receive. It is considered a , and is only used by companies that allow customers for payment of goods and services. The must reflect the same period in which a particular sale was made and can be adjusted depending on the amount left in the .
The for can be estimated by applying a flat rate to or by using historical aging data. Under the first process, also known as the method, a company that grosses $100,000 in a reporting period could estimate that three percent of their total will not be collected. Therefore, an for would be established with a balance of $3,000.
Using the aging method, all unpaid debts are categorized by time periods. For example, a company divides debts by 30 days outstanding and 60 days outstanding. By reviewing historical data, a company could determine that two percent of accounts 30 days old or less are typically unpaid, and five percent of accounts 60 days or older go unpaid. The company would report an for that is the total expected unpaid debt amounts for both categorized periods.
The second method for calculating is to use a simple direct write-off. To determine how much should be written-off, a company would take the real number of uncollected debts and divide by the total during that period to obtain a rate. This rate would show the of bad debt.
The accuracy of bad debts in is a bit tricky. Companies cannot be certain that a debt will never be paid. Therefore, they have to estimate what they believe will be uncollected debt based on past collection data. The longer a company is in business the more accurate the bad debts expense estimation can be because there is a longer aggregate history to consider.
For companies that choose not to establish a bad debt which allows a to write-off , there could be real consequences. Many business owners and managers have a difficult time believing a client won’t pay their . Unfortunately, even customers who have a wonderful payment history could encounter a problem which prevents them from being able to pay, and companies must be prepared to withstand these bad debts. Failing to create a bad debts , especially when is growing, will have a direct affect on financial planning efforts. Managers could end up with less money than projected and find themselves unable to meet their own obligations. The omission of the bad debt can also prevent management from having a true understanding of the financial health of the company.
Using as a monitoring tool, a business may find their bad debt expenses are higher than normal and becoming problematic, it could be time to review policies on extending to clients. An evaluation of these procedures could make a tremendous difference in the bottom line of a company in a very short period of time.