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How to Estimate Uncollectible Receivables?

How to Estimate Uncollectible Receivables

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How to Estimate Uncollectible Receivables

Estimating uncollectible receivables involves predicting the amount of a company’s current outstanding accounts receivable that will not be paid by customers. This is typically done using one of two methods: the allowance method and the direct write-off method. However, the allowance method is generally preferred because it aligns with the matching principle in accounting by recognizing expenses in the same period as related revenues.

There are a few common techniques to estimate uncollectible receivables using the allowance method:

  • Percentage of Sales Method: This approach applies a historical percentage to the total credit sales of the current period to estimate the bad debts. This method emphasizes the matching principle as it matches bad debt expense to the period’s revenue.Example: If a company has credit sales of $500,000 and historically, 2% of credit sales have been uncollectible, the company would record a $10,000 ($500,000 * 2%) bad debt expense.
  • Accounts Receivable Aging Method: This approach involves categorizing receivables based on how long they have been outstanding and applying a higher percentage of uncollectibility to older accounts.Example: The company’s aging schedule might look like this:
    • 0-30 days: $100,000 at 1% estimated as uncollectible
    • 31-60 days: $50,000 at 3% estimated as uncollectible
    • 61-90 days: $30,000 at 7% estimated as uncollectible
    • Over 90 days: $20,000 at 20% estimated as uncollectible
    The total estimated uncollectible amount would be: $1,000 + $1,500 + $2,100 + $4,000 = $8,600

Please note that these methods should be used consistently and in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Always consult with an accountant or finance professional when dealing with financial estimates and reporting.

Example of How to Estimate Uncollectible Receivables

Let’s use a hypothetical company, BestTech Inc., to illustrate both methods we discussed.

  • Percentage of Sales Method:
    Assume that BestTech Inc. had credit sales of $2,000,000 this year. Based on past experience, they know that typically 1% of credit sales remain uncollected. So, they can make an estimate for uncollectible receivables.Uncollectible Receivables = Credit Sales * Uncollectibility Percentage = $2,000,000 * 0.01 = $20,000In this scenario, BestTech Inc. would set aside $20,000 as an allowance for uncollectible accounts.
  • Accounts Receivable Aging Method:
    Assume BestTech Inc. has the following aging schedule for its receivables:
    • 0-30 days: $500,000, with 1% estimated as uncollectible31-60 days: $300,000, with 2% estimated as uncollectible61-90 days: $150,000, with 5% estimated as uncollectibleOver 90 days: $50,000, with 20% estimated as uncollectible
    Using these figures, they calculate their uncollectible receivables as follows:
    • 0-30 days: $500,000 * 0.01 = $5,00031-60 days: $300,000 * 0.02 = $6,00061-90 days: $150,000 * 0.05 = $7,500Over 90 days: $50,000 * 0.20 = $10,000
    The total estimated uncollectible receivables would be $5,000 + $6,000 + $7,500 + $10,000 = $28,500.So, BestTech Inc. would set aside $28,500 as an allowance for uncollectible accounts using the aging method.

This example demonstrates how the estimation of uncollectible receivables can differ depending on the method used. Companies typically choose the method that best suits their needs and gives them the most accurate estimate based on their specific circumstances.

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