Percentage of Sales Method for Calculating Doubtful Accounts
The percentage-of-sales method is commonly used to estimate the accounts receivable that a business expects will be uncollectible. When you use this method, use your small business’s past collection data to estimate what portion of the credit sales you generate each accounting period that will go unpaid. The amount of this estimated portion represents your doubtful accounts, which remain in a separate account in your records until you actually write off a specific account receivable. The amount of doubtful accounts you estimate each period reduces your profit as a bad debts expense on the income statement.
Add together the credit sales your small business generated in each of the past three years. If you started your small business fewer than three years ago, add up the credit sales you generated since its inception. For example, assume your small business generated $10,000, $15,000 and $17,000 in each of the past three years. Add these together to get $42,000 in total credit sales in the past three years.
Add together the amount of credit sales you failed to collect in each of the past three years. In this example, assume $230, $241 and $327 of your credit sales went unpaid in each of the past three years. Add these together to get $798 in total uncollected credit sales.
Divide your total uncollected credit sales by your total credit sales. Multiply your result by 100 to determine the percentage of your credit sales you failed to collect over the past three years. In this example, divide $798 by $42,000 to get 0.019. Multiply 0.019 by 100 to get 1.9 percent in uncollected credit sales.
Adjust the percentage of uncollected credit sales to reflect any changes that might affect your collections in the current period. Changes that might cause you to lower the percentage include an improving economy or an increase in creditworthy customers. A declining industry might warrant an increase in the percentage. In this example, assume overall economic growth will improve collections by 0.1 percent. Reduce 1.9 percent to 1.8 percent to reflect the change.
Multiply your result by the amount of credit sales you generated in the current period to determine the amount of your doubtful accounts for the period. Concluding the example, assume you generated $5,000 in credit sales in the current quarter. Multiply 1.8 percent, or 0.018, by $5,000 to get $90 in doubtful accounts. This means $90 out of your $5,000 in credit sales will likely be uncollectible based on your previous uncollectible accounts.