3.1. Calculating allowance under percentage-of-receivable approach

The rate can be estimated either as a composite rate (i.e., total uncollected amounts divided by total gross receivables) or as a set of rates based on the aging of accounts receivable. The first one – composite rate – is self-explanatory and may not be as accurate as the second one – a set of rates based on receivables aging. Thus, we will review the accounts receivable aging method in more detail.

Accounts receivable aging represents a schedule showing how long amounts comprising the total accounts receivable balance have been outstanding.

An example of such aging for Company XYZ as of December 31, 20X2 is provided below:

(*) The total balance column equals the sum of amounts in columns to the right.

Most accounting software packages are capable of producing such aging reports (and if not, maybe a different accounting software package should be considered).

This aging report can be summarized by aging “buckets” as follows:

This aging report shows that amounts which are current (i.e., not overdue) equal $76,000; amounts which are overdue by 31-60 days equal $14,000; and so forth. The total gross accounts receivable balance is $100,000.

Next, to calculate the required balance in the allowance for doubtful accounts, Company XYZ needs to apply rates of uncollectable amounts. Assume that the company determined (based on prior experience with collecting outstanding amounts from customers) that the percentages are 1%, 5%, 10%, 25%, and 50% for respective aging “buckets.” The company can estimate the allowance for doubtful accounts as follows:

For example, the allowance amount for the current “bucket” is $760 = $76,000 x 1%. You can also see that the rate increases with the aging of accounts receivable. That appears logical because the longer an amount is outstanding from a customer, the less probable it is that the amount will be collected.

Note: A company is not required to utilize the same aging “buckets” as those provided in our example. In addition, the rates for different aging “buckets” provided in the table above will differ from one company to another because such rates depend on the company’s experience with accounts receivable collections.

Finally, assume that before any adjustments the balance in allowance for doubtful accounts of Company XYZ at December 31, 20X2 was $350. The balance that should be in this account after the adjusting entry equals $3,310 (see table above). Thus, the company should make such an adjustment so that the balance becomes $3,310:

$2,960 = $3,310 - $350

And the journal entry that Company XYZ would post is as follows:

When a particular account becomes uncollectible in a later period, the company will write it off against this allowance balance. For instance, if during 20X3 the company learnt that the $1,000 balance due from Customer F became uncollectable, the company would make the following entry:

As with the percentage-of-sales approach, the percentage-of-receivables approach only impacts the income statement when the allowance of doubtful accounts is adjusted (i.e., uncollectible balance is estimated). When a particular account becomes uncollectible and is written off, there is no impact on the income statement. The percentage-of-receivable approach satisfies requirements of the matching principle as well, even though it may not be as precise in terms of matching revenues and bad debt expenses as the percentage-of-sales approach.

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