Percentage-of-sales approach and percentage-of-receivables approach

3. Explanation of percentage-of-receivables approach

Percentage-of-receivables approach (balance sheet approach) states that the amount of doubtful accounts at the end of a reporting period can be calculated by applying a percentage of estimated uncollectable amounts to gross accounts receivable. This approach takes into consideration the balance in allowance for doubtful accounts.

Percentage-of-receivables approach is different from percentage-of-sales approach in that it uses gross accounts receivable balance to estimate allowance for doubtful accounts. That is why this approach is also called a balance sheet approach. As you will see further, the bad debt expense is a balancing amount between what the allowance should be under the percentage-of-receivables approach and what it actually is at the end of a reporting period. Contrary, the percentage-of-sales approach directly calculates the amount of bad debt expense while the balance of allowance for doubtful accounts becomes a derivative of the previous period balance in this account, bad debt expense recorded during the period, and bad debt write-offs during the period.

Percentage-of-receivables approach is usually considered to be somewhat less precise in meeting the requirements of the matching principle. However, this approach is better at estimating the true net realizable value of accounts receivable.

A company should perform an analysis of historical data and determine what percentage of accounts receivable at a point in the past subsequently became uncollectable. The calculated percentage then can be applied to accounts receivable of the current period to estimate the allowance for doubtful accounts. Note: A company should perform an analysis of historical data; however, blind application of the determined rate to the current period accounts receivable may not be appropriate when circumstances change (e.g., credit terms were modified). In such a case, the company should consider such changes and adjust the determined rate based on management judgment.

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