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June 01, 2022 June 01, 2022/ Steven Bragg
The percentage of receivables method is used to derive the bad debt percentage that a business expects to experience. The technique is used to populate the allowance for doubtful accounts, which is a contra account that offsets the accounts receivable asset. At the most basic level, the percentage of receivables method requires the following steps:
Obtain the ending trade accounts receivable balance listed in the balance sheet.
Calculate the historical percentage of bad debts to accounts receivable.
Multiply the ending trade receivables balance by the historical bad debt percentage to arrive at the amount of bad debt to be expected from the ending receivables balance.
Compare this expected amount to the ending balance in the allowance for doubtful accounts, and adjust the allowance as necessary for it to match the latest calculation.
A problem with the preceding calculation is that it may not be sufficiently refined; it does not account for different ages of accounts receivable, only the grand total of all receivables. A better approach is to print an aged accounts receivable report as of the end of the reporting period that contains 30-day time buckets, and apply the historical bad debt percentage for each time bucket to the bucket totals in the report. For example, the loss rate for current receivables may be only 1%, while the loss rate for receivables older than 90 days may be 50%.
Another issue is to not use an excessively long time period to derive the historical bad debt percentage, since changes in the economic environment may have altered the loss rate. Instead, consider using the historical loss rate for the past 12 months on a rolling basis.
June 01, 2022/ Steven Bragg/
Learn about percentage-of-sales approach and percentage-of-receivables approach in calculating allowance for doubtful accounts and bad debt expense.
1. Matching revenues with expenses (matching principle)
The matching principle in accounting states that revenues should be matched with expenses incurred in generating those revenues. In other words, expenses incurred to create revenues should be included in the income statement in the same reporting period as the revenues.
When a company sells products or provides services on account (i.e., credit sales), almost always there is a risk that some outstanding amounts due from customers will not be collected. Customers may become bankrupt or refuse to pay for a variety of other reasons. Such amounts are called uncollectible and represent an expense to the company. The expense is called bad debt expense. However, there is usually a time lag between the period when a customer purchases a product or service and the period when it becomes known that the balance due from the customer will not be collectable. Therefore, a company needs to estimate how much of its accounts receivable will be uncollectable. Such uncollectible amounts should be recorded in the period of related sales to satisfy the matching principle. In particular, the estimated bad debts (i.e., amounts that the company thinks will be uncollectible) are recorded as an expense in the same period as the sales revenues that created the potentially uncollectable amounts due from customers.
The amounts deemed by a company to be uncollectible are recorded in a contra-asset account called allowance for doubtful accounts. This account is subtracted from gross accounts receivable to arrive at net realizable value of accounts receivable on the balance sheet. There may be several methods to estimate how much of accounts receivable will eventually be uncollectible. Two of such methods are the percentage-of-sales approach and the percentage-of-receivables approach. Applying such approaches falls within the allowance method of accounting for bad debts.
Note that there is also a direct write-off method of accounting for bad debts. Under this method a bad debt is recognized as an expense when it becomes known that the amount due from a customer is uncollectable. Unless amounts involved are immaterial, using the direct write-off method is not in accordance with US GAAP because the matching principle is not satisfied in most cases.
After we have covered some basics about the allowance method of accounting for bad debts, let’s review in more detail the percentage-of-sales and percentage-of-receivables approaches.
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By Danielle Smyth Updated November 16, 2021
The terms "percentage of sales" and "percentage of receivables" may or may not be familiar to you. They are two ways of reconciling accounts where you cannot collect the actual outstanding balances from the parties who owe them. While they have the same result and the same goal, they're quite different. As a business owner or manager, it's crucial to understand what they are and how to calculate them. In this manner, you can make the best choices for your business.
The percent of accounts receivable method is used by businesses and business sectors to determine how much bad debt they expect to incur compared to sales. Unfortunately, not everyone pays their bills. This occurs for several reasons, but sound businesses need to anticipate some bad debt.
Businesses can use different methods to arrive at an actual number, and they use this estimate to offset their projected gross income or sales for the year. They may use past percentages, compare their numbers to businesses in the same sector, other factors, or a combination of these. According to the team at Lumen Learning, no matter how you arrive at the amount, the percentage of receivables method is essentially a way of calculating uncollectable accounts.
The percentage-of-receivables method is an estimate. The best and most reliable method is to use your own business's past numbers and performance. Look at the previous year's numbers and determine how much bad debt you had. Calculate that as a percentage of your total accounts receivable. To get the most accurate number, you may want to look at the past several years and arrive at an average.
This step may not make sense in some cases, especially if your client base has changed dramatically or you've implemented different accounting practices.
Next, look at your projected accounts receivable total. (If you haven't figured it out yet, this is one of the last steps you take when making your budget.) Multiply that number by the percentage of sales that become bad debts. Subtract that number from your projected end-of-year (or whatever accounting period you're working in) total sales.
Percentage of sales is another forecasting method. In some ways, the percentage of receivables method is a type of percentage of sales. However, business owners can use it to calculate expenses, such as the costs of purchased goods and bad debts.
Calculating all the costs, including traditional expenses such as office space rental, employee salaries and equipment, is essential. Doing so allows businesses to create a more accurate picture of their financial health and projected profits. It is also helpful for potential or current investors.
To calculate the percentage of sales to expenses, you first need to collect all the numbers. Calculate your total sales for the period and then calculate the total costs for that same period, HubSpot explains. Next, divide the expenses total by the sales total. Multiply that number by 100 to provide the percentage of sales to costs.
Hopefully, the number you end up with is minimal, and your sales greatly outweigh your expenses. If the number you end up with is more than 100 percent, your business might be in trouble. This signals that your business is spending more than it is taking in for income.
Sometimes this is OK. For example, if you're going through a significant expansion or just starting up, you can anticipate spending more than you bring in. However, it shouldn't be a surprise. You should be able to cover this spike in expenses with past income reserves, savings and equity.