Estimating Bad Debts Financial Accounting

One way companies derive an estimate for the value of bad debts under the allowance method is to calculate bad debts as a percentage of the accounts receivable balance. The estimation is typically based on credit sales only, not total sales (which include cash sales). In this https://adprun.net/understanding-the-cost-of-bookkeeping-for-small/ example, assume that any credit card sales that are uncollectible are the responsibility of the credit card company. It may be obvious intuitively, but, by definition, a cash sale cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency.

What’s even better is that you can take things one step further and try and prevent bad debts if you have the right software. With loan servicing software like LoanPro, you can mitigate risks and improve relationships with your customers at the same time. Let’s say your business has $450,000 in sales for the current year, and you want to know what your bad debt allowance should be. It’s almost the same formula as above, but the unknown variable has changed, and you’re calculating for the current period instead of looking at your historical averages. Now, you can use this percentage to estimate bad debt for your current period and determine your bad debt reserve.

Why is bad debt the most important thing in your business?

Bad debt expenses make sure that your books reflect what’s actually happening in your business and that your business’ net income doesn’t appear higher than it actually is. Accurately recording bad debt expenses is crucial if you want to lower your tax bill and not pay taxes on profits you never earned. As of January 1, 2018, GAAP requires a change in how health-care entities record bad debt expense.

The percentages will be estimates based on a company’s previous history of collection. Accounts receivable is a permanent asset account (a balance sheet item) while sales is a revenue account (an income statement item) that resets every year. As a result, the steps you’ll take to estimate your AFDA in this method are different compared to the percentage of sales method. If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense.

Estimating the Bad Debt Expense

This advanced planning will help you ensure that your business remains financially healthy and is able to withstand any unexpected losses caused by late or unpaid invoices. By working out your company’s bad debt expense formula, you can better understand how much bad debt you are likely to incur and plan for it accordingly. The direct write-off method is the simplest way to calculate bad debt, as it involves nothing more than listing a transaction on your Profit and Loss statement. It also offers an accurate representation of bad debt in the period that it occurred. It simply involves writing off any bad debts as a loss when you become aware that they are likely to be unrecoverable. The first step in resolving any bad debt issues is to understand how much you are owed, which is where your bad debt expense formula comes in.

Once this account is identified as uncollectible, the company will record a reduction to the customer’s accounts receivable and an increase to bad debt expense for the exact amount uncollectible. A reserve for doubtful debts can not only help offset the loss you incur from bad debts, Bookkeeping, tax, & CFO services for startups & small businesses but it also can give you valuable insight over time. For example, your ADA could show you how effectively your company is managing credit it extends to customers. It can also show you where you may need to make necessary adjustments (e.g., change who you extend credit to).