Accounting estimates are a significant part of the financial statements that require the use of judgment by management based on knowledge and experience of past and current events. It’s important that these estimates are accurate so that the financial statements portray a fair representation of the financial position of the company in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”). The allowance for doubtful accounts is one example of an important estimate made by management and there are several methods to use in determining the estimate.
What is an Allowance for Doubtful Accounts?
The allowance for doubtful accounts is used to anticipate that some accounts receivable will not be collected. U.S. GAAP states that the conditions under which receivables exist usually involve some degree of uncertainty about their collectability, in which case a contingency exists. The loss from uncollectible receivables needs to be reflected on the income statement and balance sheet in order to present a fair depiction of the state of the company. For instance, if an organization made a sale to a customer on credit one year ago and that amount is still outstanding, there is a good chance that the money will never be collected. Presenting that sale on the balance sheet as an account receivable would be misleading to the users of the financial statements. U.S. GAAP requires the accrual of losses from uncollectible receivables if a loss is probable and the amount of the loss can be reasonable estimated (FASB ASC 450-20-25-2).
Methods to Calculate an Allowance
Authoritative literature does not provide requirements on methods to develop an allowance for doubtful accounts. There are various methods used in practice such as the sales or income statement approach, which uses a percentage of the company’s total sales for the period, or the balance sheet approach, which uses a percentage of accounts receivable for a period.
The income statement approach is an approach by which management can estimate an allowance for uncollectible receivables as a percentage of the period’s sales. An allowance as a percentage of sales is an effective approach when the company has past experience or history to use as a guide. For example, if a company’s bad debt expense as a percentage of sales has historically been between 3% and 5% for the past 5 years, a reasonable allowance using the income statement approach would be 4% of sales for the current period. As the credit quality of the company’s customers improves or deteriorates over time, the percentage used for the allowance can be adjusted up or down accordingly.
A newer company, which would not have a history of past write-offs and good credit history with customers, would not benefit from the income statement approach for estimating their allowance for doubtful accounts but rather a balance sheet approach. The balance sheet approach estimates the allowance for doubtful accounts based on the accounts receivable balance at the end of each period. A useful tool in estimating the allowance would be the accounts receivable aging report, which states how far past due specific customers balances are that make up accounts receivable. The longer the balance has been outstanding, the higher the likelihood that the balance will not be collected. Management should first review the aging report and specifically identify the accounts with the highest risk of nonpayment and reserve for those accounts individually. Then management should estimate the risk of nonpayment of the customer accounts remaining in each of the aged categories with a higher percentage allocated to the significantly aged accounts and a lower percentage to the recently billed accounts.
Some companies may use a hybrid method utilizing the balance sheet and income statement approach. A company may use an income statement approach and record an allowance based on a percentage of sales, and then adjust the allowance based on a specific review and analysis of the accounts receivable aging report. Management can adjust the allowance based on credit worthiness of a specific customer, risks identified, or change in current write-off history.
Estimates are the responsibility of management to improve the accuracy of the presentation of the financial statements. When a receivable exists there is a degree of uncertainty about the collectability of that receivable and per U.S. GAAP that uncertainty should be estimated and recorded. All methods require management to determine a percentage estimate based on their understanding of the industry, current economic factors, and the customers’ payment history and credit worthiness.