Bookkeeping – Estimating Bad Debts (Lesson 85)
The most annoying part of owning a small business is when the customer fails to pay for items purchased or services rendered. Not only is this a personal insult it also greatly affects cash flow in a business. The reality is that some customers can’t pay their bills. Tolerating non-payment is simply a part of doing business. To assist in measuring this dollar value, the accountant must estimate bad debts. This is the fifth part in the series of bookkeeping estimates within the advanced skills section of bookkeeping.
Bad debts are a function of accounts receivable in business. An estimate of the amount that will not be paid is necessary to match revenue generated against actual costs to earn that revenue. Bad debts are customarily recorded as an expense to the accounting records. Some entities will use this value as an offset against revenue. In general, bad debt offsets revenue when non-payment or adjustments are common in the particular industry. An example is the practice of medicine; nonpayment and adjustments are quite common, therefore bad debt is a contra account in the revenue section of the financial reports.
This lesson explains two different methods of estimating bad debt. The most common method is the gross percentage method based on historical patterns. The second method is the specific identification tool. Each is used under certain conditions and with restrictions.
In addition to these two methods are some modifications to the chart of accounts along with how the entry is posted. I’ll explain both. Finally, there are/some insights appropriate to estimating bad debts that will help the accountant explain the formulas and underlying justification for the amounts estimated. Let’s get started.
Gross Percentage Method of Estimating Bad Debt
In psychology there is a familiar saying, ‘behavior predicts behavior’. This same thought process is used with money owed by customers to a business. In business statistics it represents a tendency towards a particular trend when considering a large group of customers. There is a tendency for a predictable default rate. Basically a certain percentage of customers will fail to pay their bills. The reasons vary from the extreme (such as death) to the benign (they simply forgot). The most common is insolvency and bankruptcy.
The gross percentage method simply looks at the historical pattern and determines an expected percentage for the current pool of accounts receivable to estimate the amount of uncollectible value to report as bad debt.
The process involves using a spreadsheet to calculate the overall average. Here is an example:
DISCOUNT OFFICE FURNITURE
2011 – 2015
2011 2012 2013 2014 2015 Total
Sales on Account $1,307,410 $1,351,891 $1,293,605 $1,482,693 $1,510,809 $6,946,408
Uncollected $23,614 $29,451 $23,071 $34,886 $40,715 $151,737
Uncollectible % 1.81 2.18 1.78 2.35 2.69 2.18
In the above example the running average is 2.18% of all sales done on account. It is important to emphasize that if the calculation is performed with all sales, the percentage would be significantly less. Here is an example for 2015.
Sales (Cash) $43,119
Sales (Credit/Debit Cards) 397,953
Sales (Direct Deposit) 910,556
Sales on Account 1,510,809
Total Sales $2,862,437
The other sales significantly decrease the percentage of uncollectible. If the ratio of sales on account against all sales remain stable, then using uncollectible as a percentage of total sales is acceptable. But the more accurate relationship is uncollectible as a percentage of sales on account.
In the above five year spreadsheet notice that the last two years have higher uncollectible percentages than 2011 through 2013. The running average is weighted lower from the 2011 through 2013 averages. In this situation it is wiser to use a higher uncollectible percentage such as 2.4 or 2.5 as the estimated rate due to the recent increase in uncollectible rates. The rule here is that more recent percentages have greater weight in the formula than a rate from several years ago.
As an accountant your goal is to get it as accurate as possible. Sometimes it is as simple as using the specific identification method.
Specific Identification Method of Estimating Bad Debt
The specific identification method is based on reviewing the existing invoice pool and identifying those invoices that will most likely not get paid. This is performed by the accounts receivable manager using notes created as a step in receivables management. Those receivables older than 90 days are evaluated for payment. Any invoice with a high likelihood of non-payment is included in the list of uncollectible status. Again, those notes are an essential element in the decision process. Not all aged receivables will default; some are tied to long-term contracts or keyed to the completion of a certain step in a process.
For example, I had an electrical supplier that shipped distribution panels to a hospital for a new wing. The receivables were over 90 days but the hospital’s funding was tied to funding released upon an inspection. It is not uncommon in many businesses to have extended payment plans triggered by certain events. Think about:
* Farming supplies paid after a harvest;
* Stevedore services in the ocean shipping/fishing industries; AND
* Government contracts
Application of Methods
Both methods work well in certain industries and it is important to differentiate between the two.
The gross percentage method is ideal in the high volume, small dollar amounts of invoices business. This includes transportation, food service, medical practices, printing, suppliers and consumer goods retail. The general rule of thumb is a minimum of 100 invoices per month. If greater than 100 per month, use the gross percentage method; less than 100 use the specific identification tool.
Create a spreadsheet specifically designed for this purpose. Create one tab for each month and a summary worksheet at the beginning. Determine an aggregate balance for the year to date in the summary page. The change in value from month to month is the amount posted as bad debt for that accounting period. If the annual expected bad debt is $7,200, then on average ,the monthly bad debt will tend towards $600.
It is now time to post the dollar value. Prior to posting, the respective ledgers must be set up in the chart of accounts. A contra account is set up against accounts receivable. This value is approximate the annual estimated amount. This allows all invoices to remain in the accounts receivable control account until it is finalized as to their determined uncollectible status. The control account has various names including
* Uncollectible Accounts
* Estimated Bad Debts
* A/R Offset
I personally prefer estimated uncollectible amounts. The basic entry is a debit to bad debt and a credit to the contra account. The question for most accountants is: is bad debt a revenue, cost of sales or expense type of account?
Generally Accepted Accounting Principles considers bad debt as an expense, specifically a capital cost. It is a function of collections and setting customer credit guidelines. However, if the bad debt percentage is significant ( >3% ) it should be located in the revenue section as a contra account. In small business, there is no hard rule to this account location; but in reality, uncollectible accounts are similar to discounts. Here is a well structured revenue section for a small business:
Gross Sales $ZZZ,ZZZ
– Discounts ($ZZ,ZZZ)
– Bad Debt (Z,ZZZ)
Sub-Total Adjustments (ZZ,ZZZ)
Adjusted Gross Sales ZZZ,ZZZ
Returns and Allowances:
– Returns (Z,ZZZ)
– Allowances (ZZ,ZZZ)
Sub-Total Returns & Allowances (ZZ,ZZZ)
Net Sales ZZZ,ZZZ
Other Revenue Z,ZZZ
Total Revenue $ZZZ,ZZZ
Over on the balance sheet, estimated uncollectible amounts are a part of the accounts receivable section within current assets. Take note, this is a contra account to receivables. The following is the limited scope presentation without the customary header.
– Cash $ZZZ,ZZZ
– Inventory ZZ,ZZZ
– Accounts Receivable ZZZ,ZZZ
– Estimated Uncollectible (ZZ,ZZZ)
– Prepaid Expenses Z,ZZZ
Sub-Total Current Assets $ZZZ,ZZZ
Notice how both accounts for bad debt are contra accounts when placing the bad debt expense in the revenue section of the income statement. If bad debt is in the expense section, it is a traditional debit account located in a type of accounts that are traditionally debit based. The entry is made via the general journal and is done monthly. Its value is different depending on the method used as explained below.
This method is simply a mathematical computation and an actual write-off. The computation step is designed to identify the estimated amount of many invoices that will not get paid. This is an excellent tool for retail driven accounts. Since it is a function of the volume of gross sales on account, a simple formula in the spreadsheet determines the actual dollar amount. The entry is a debit to bad debt contra and a credit to estimated uncollectible amounts as follows:
Date ID Ledger Description DR CR
10/31/ZZ EOM-017(DJH) Bad Debt Oct’s Est. Bad Debt BD16-10 Z,ZZZ
EOM-017(DJH) Est. Uncollect. Oct’s Est. Bad Debt BD16-10 Z,ZZZ
Take note of two important details:
1) There is no control ID as the specific invoices and customers that will not pay have yet to be identified.
2) In the description field, always identify the spreadsheet and tab that cues the reader to the formula. In this case BD16-10 means the bad debt spreadsheet for 2016 under tab10 (October).
To appreciate this, let’s walk through the logic to cover bad debt processing. The above merely places an estimated value on the income statement based on a historical pattern of uncollectible amounts. It offsets the receivables balance so both accounts (receivables and the contra value) inform the reader of the actual amount of invoices that will be collected. If this pattern continues indefinitely, the contra value will just continuously grow and the accounts receivable value will also grow as the particular uncollectible invoices remain in the ledger. There must be a way to remove these uncollectible invoices.
Good accounts receivable management uses a two-step process to remove uncollectible invoices. The first step separates troubled invoices from the regular pool of invoices. The second step is to actually write-off the respective invoice. Here are the steps in detail.
Separate Troubled Invoices
Every company develops a policy to separate (identify) out troubled invoices. Some policies are as simple as using an aging threshold such as 90 days or 120 days from the date of sale. Others use age and customer status like below:
A) Excellent – invoices are allowed to age to 180 days overdue (approximately 120 days from the sale date).
B) Good – invoices may age upwards of 150 days from overdue date (180 days from sale date).
C) Regular – invoices may age up to 90 days overdue.
Whichever policy is used, it is imperative that the accounts receivable accountant properly manage the invoice pool. Once the invoice meets the criteria of being a problem it is transferred to an account for collections. A secondary accounts receivable is created called collections. When the invoice goes into collections, use of more aggressive tactics to collect money are warranted including:
* Collection Letters
* Filing of Warrants in Debt
* Seeking Judgement in Court
* Posting of Credit Discrepancies to Credit Bureaus
* Phone Calls
* Payment Plans
* Transfer to Credit Card Payment
This separation of dollar amounts allows the reader to understand the entire picture of accounts receivable as illustrated here:
– Cash $ZZZ,ZZZ
– Inventory ZZ,ZZZ
– Accounts Receivable ZZZ,ZZZ (Accounts Receivable in Excellent Status)
– Collections ZZ,ZZZ (Accounts in Collection Process)
– Estimated Uncollectible (ZZ,ZZZ) (Expected Amounts to Write-off)
– Prepaid Expenses Z ZZZ
Sub-Total Current Assets $ZZZ,ZZZ
Please note that the dollar value in collections will never match the dollar value of estimated uncollectible. Why? Because the estimated value will include associated invoices in accounts receivable, i.e. current sales that will ultimately default.
The actual entry to move an invoice to collections is via the general journal or the sales journal (I advocate the general journal). The entry is made whenever the invoice meets the criteria for transfer (date and/or customer status). It is as follows and note the inclusion of the customer’s ID in the entry.
Date ID Ledger Control ID Description DR CR
11/12/16 574203 Accounts Rcvb Smith-06 Inv.#160612L 208.23
574203 Collections Smith-06 Inv.#160612L 208.23
Again, the invoice is not written off, it is simply transferred (reclassified) to collections. Once collection procedures are exhausted it is time to actually write this asset off the books of record.
Once an invoice has been determined worthless it is time to eliminate this invoice from the books. Since an estimated bad debt was determined way back at the point of sale, this elimination process will not affect the financial position of the company. In effect, neither the net current assets or current net earnings change. It merely cleans up the books. This step involves transferring the invoice in collections to the estimated uncollectible amounts as follows:
Date ID Ledger Control ID Description DR CR
02/12/17 835152 Collections Smith-06 Remove Inv.#160612L 208.23
835152 Est. Uncollectible – Smith-06 #160612L 208.23
It is a wise idea to have a file on Smith-06 whereby the invoice and all collection procedures are copied to the file. If money does come in it can be documented. Also, when customers don’t pay it is almost always a bankruptcy issue and the trustee will provide an opportunity to make a claim and at least the documentation is available to validate and substantiate the claim.
The specific write-off method is very similar to the gross percentage method except there is no computation involved. Use the general journal to move the particular invoice from accounts receivable to collections status. This entry actually has a double entry by creating the estimated write-off at the same time. The specific write-off method usually has a matching of amounts in collection with the estimated uncollectible value. Once all means of collection are exhausted simply remove the specific invoice and its corresponding contra value.
Estimating bad debt is designed to accrue amounts expected to go unpaid. The ultimate goal is to reduce revenue by the amount anticipated as uncollectible. The key is the expected uncollectible amount. The accountant’s experience with customers and their behavior is the number one tool to estimate uncollectible amounts. The accountant can tell the likelihood of payment by the tone of voice from the customer or customer’s accountant. Use this to identify invoices that have or will have issues.
Follow a good accounts receivable management program to reduce the default rate with collecting amounts owed. If the default rate increases, change the credit criteria and shift to alternative payments from customers including credit cards or third-party financing.
Use the spreadsheet wisely and track the circumstances for default. Are they tied to a particular salesman, geographical territory or a particular sub-industry? By identifying trends or characteristics of customers the company can reduce future default rates.
Summary – Estimating Bad Debt
Bad debt is the estimated amount of uncollectible sales processed on accounts with customers. It is quite normal for a business to experience bad debt as customers will have solvency issues. The accountant estimates the expected bad debt by using one of two methods.
A) Gross Percentage – uses the historical actual to estimate expected bad debt for the current accounting period. This method works well with high volume activity and low dollar value amounts per invoice.
B) Specific Write-Off – requires an experienced accountant familiar with customer patterns to identify which specific invoices will be uncollectible. This tool is ideal with high dollar invoices and very few customers.
Create a contra account in the current assets section to receive the credit value of the respective estimate. The debit side of this entry is posted to either a contra account in the revenue section or to the expense section of the income statement. ACT ON KNOWLEDGE.
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