Any given fiscal year your business will experience the need to write off a portion of its customers' accounts as uncollectible. A monthly accrual for the anticipated loss can help to minimize the impact of the write offs on your financial statements at year end. There are two acceptable methods of calculating doubtful debt.
Doubtful Debt Based on Sales
Doubtful debt can be calculated as a percentage of your net credit sales for the given month. This method is consistent with the Matching Principle in that the doubtful debt is expensed in the same period as the sales associated with the expected loss. The percentage that your company will write off is an estimate based on your company's historical collections of its receivables and is at the discretion of the financial management team, however common percentages range from 0 percent to 4 percent.
Doubtful Debt Based on Receivables
Estimating the doubtful debt expense for a given month based on the receivables balance is also an acceptable method of calculation. This method takes into account the balance already in the provision for doubtful debt account. The percentage used in this method is again a discretionary estimate.
Writing Off Accounts Receivable
When you have provided for the likelihood that some of your customers will not be able to pay you for the products or services you provided, writing off these losses will not affect your bottom line. The loss will be recorded as a debit to the provision for doubtful debt and a credit to your accounts receivable balance. Occasionally you will recover an accounts receivable write off. When this occurs the necessary adjustment is a debit to accounts receivable and a credit to provision for doubtful debt. Now the payment can be recorded as it normally would.
The benefits of the allowance method for accounting for doubtful debt is simple. Expensing your estimated losses each month will offset the revenue for the month affected by the loss. If you don't account for these losses on a monthly basis, your income statement will likely take a big hit at the end of the fiscal year. This will have a negative impact on your financial statements and may impact your company's ability to obtain credit and attract investors.
Assume your company has net credit sales for the month of June of $50,000. You estimate that your doubtful debt will be 2 oercent. Calculating doubtful debt as a percentage of sales you would make the adjustment as a debit to doubtful debt expense of $1,000 and a credit to allowance for doubtful debt of $1000.
Alternatively assume at the end of June your receivables total $100,000. If you estimate your doubtful debt to be 1 percent of this total and your provision for doubtful debt is balance is a credit of $500, you would debit doubtful debt expense and credit the provision for bad debt expense for $500 to bring the total provision for doubtful debt to the desired $1000, or 1 percent of receivables.