Percentage of Receivables Method
The percentage of receivables method, also known as the balance sheet approach, is an accounting technique used to estimate the amount of a company’s accounts receivables that may end up uncollectible. This method focuses on adjusting the balance of the allowance for doubtful accounts on the company’s balance sheet.
The method works by applying a certain percentage (based on historical data and management’s judgment) to the total amount of accounts receivable, or sometimes applying different percentages to accounts receivable in different aging categories.
Here’s a simplified example of how this method might be used:
- A company determines that based on past experience and current economic conditions, it’s likely that 2% of its total accounts receivable will be uncollectible.
- If the company currently has $500,000 in total accounts receivable, it would then record an adjusting entry of $10,000 (500,000 * 2%) to its allowance for doubtful accounts. This $10,000 is recognized as bad debt expense on the income statement.
- This increases the balance in the allowance for doubtful accounts, which is a contra asset account that reduces the total accounts receivable reported on the balance sheet to its net realizable value – the amount the company expects to actually collect.
This method helps companies to better match revenues with expenses, by recognizing the expense of bad debts in the same period as the revenue related to those receivables is recognized. However, it relies on the accuracy of the estimated percentage, which can be influenced by a variety of factors.
Example of the Percentage of Receivables Method
Imagine a company called TechCorp has total accounts receivables of $100,000 at the end of the year. Based on its past experiences and current economic conditions, TechCorp estimates that 3% of its receivables will likely be uncollectible.
Here’s how to calculate the allowance for doubtful accounts and record the necessary journal entries:
- Calculate the allowance: TechCorp would calculate its allowance for doubtful accounts as 3% of $100,000, which equals $3,000.
- Record the bad debt expense: TechCorp would then record an adjusting entry debiting (increasing) Bad Debt Expense for $3,000 and crediting (increasing) the Allowance for Doubtful Accounts for $3,000. This reflects the estimate of the receivables that are expected to become uncollectible.Journal Entry:
- Debit Bad Debt Expense: $3,000
- Credit Allowance for Doubtful Accounts: $3,000
Now, on the balance sheet, TechCorp’s net accounts receivable (Accounts Receivable minus Allowance for Doubtful Accounts) would be reported as $97,000, representing the amount it expects to collect.
Remember, the actual amount of accounts receivable that ends up uncollectible may be higher or lower than this estimate. If the estimate changes, TechCorp would adjust the Allowance for Doubtful Accounts and the Bad Debt Expense accordingly.