Question

Explain the percentage of accounts receivable and the accounts receivable aging allowance methods.

Answer 1

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:

1. Obtain the ending trade accounts receivable balance listed in the balance sheet.

2. Calculate the historical percentage of bad debts to accounts receivable.

3. 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.

4. 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%.

Definition of Aging Method

The aging method usually refers to the technique for estimating the amount of a company's accounts receivable that will not be collected. The estimated amount that will not be collected should be the credit balance in the contra asset account Allowance for Doubtful Accounts. The debit balance in Accounts Receivable minus the credit balance in Allowance for Doubtful Accounts will result in the estimated amount of the receivables that will be converted to cash.

The aging method sorts each customer's unpaid invoices by invoice date into perhaps four columns:

• Column 1 lists the invoice amounts that are not yet due
• Column 2 lists the invoice amounts that are 1-30 days past due
• Column 3 lists the invoice amounts that are 31-60 days past due
• Column 4 lists the invoice amounts that are more than 61 days past due