How Is Bad Debts Expense Calculated With Aging of Receivables?

Bad debts expense represents an estimated cost of sales that a company will not collect from its customers. This estimation is important for financial reporting, as it helps companies present an accurate picture of their financial health and the true value of their assets. Businesses anticipate that some outstanding customer payments, known as accounts receivable, will prove uncollectible. The aging of accounts receivable method is a widely used approach for this estimation.

Understanding Accounts Receivable and Uncollectible Accounts

Accounts receivable (AR) refers to money owed to a company by its customers for goods or services provided on credit. These amounts typically arise from sales made on credit terms, with payment expected within a specified period, such as 30 or 60 days. Some accounts receivable will inevitably become uncollectible, leading to bad debts.

Bad debts occur for various reasons, including customer bankruptcy or financial distress. Accounting standards require companies to estimate these uncollectible amounts to ensure financial statements accurately reflect asset values. This estimation aligns with the matching principle, which dictates expenses should be recognized in the same period as the revenues they helped generate. By estimating bad debts when the credit sale occurred, a company matches the expense of potential non-collection with the revenue from the sale.

The Aging of Accounts Receivable Method Explained

The aging of accounts receivable method estimates the portion of outstanding customer debts a company expects not to collect. This approach categorizes accounts receivable based on how long each invoice has been outstanding. Common age categories include current, 1-30 days past due, 31-60 days past due, 61-90 days past due, and over 90 days past due.

Each age category is assigned a different estimated uncollectibility percentage. The longer an account remains unpaid, the less likely it is to be collected. For instance, a current invoice might have a low uncollectibility estimate (1-2%), while an invoice over 90 days past due might have a much higher estimate (40-50% or more). This method assumes older debts carry a higher risk of becoming bad debts.

Uncollectibility percentages are determined based on a company’s historical collection experience, industry averages, and current economic conditions. Companies analyze past data to establish realistic percentages for each age bracket. This detailed categorization and percentage application allow for a more precise estimate of uncollectible accounts.

Calculating Bad Debts Expense

Calculating bad debts expense using the aging of accounts receivable method determines the desired ending balance in the Allowance for Doubtful Accounts. This calculation begins by preparing an aging schedule. An aging schedule lists each customer’s outstanding balance and breaks it down into age categories. For example, if a customer owes $1,000, and $400 is current while $600 is 35 days past due, these amounts are placed into their respective age columns.

Once the aging schedule is complete, the estimated uncollectibility percentage is applied to the total dollar amount in each age category. For instance, if accounts 1-30 days past due total $50,000 with 5% uncollectibility, $2,500 is estimated as uncollectible. Similarly, for accounts over 90 days past due totaling $10,000 with a 45% uncollectibility rate, $4,500 would be estimated as uncollectible. These percentages reflect the increasing risk of non-collection as debts age.

The next step involves summing the estimated uncollectible amounts from all age categories. This sum represents the total estimated uncollectible accounts, which is the desired ending balance for the Allowance for Doubtful Accounts on the balance sheet. For example, if the sum of all estimated uncollectible amounts is $12,000, then $12,000 is the target balance for the Allowance for Doubtful Accounts. This target balance reflects the company’s best estimate of the portion of its accounts receivable that will not be collected.

To determine the bad debts expense for the current period, the existing balance in the Allowance for Doubtful Accounts must be considered. The Allowance for Doubtful Accounts is a contra-asset account, reducing gross accounts receivable to their net realizable value. If the Allowance for Doubtful Accounts has a credit balance of $1,000 and the desired ending balance is $12,000, the bad debts expense would be $11,000 ($12,000 – $1,000). If it has a debit balance of $500, the bad debts expense would be $12,500 ($12,000 + $500). This adjustment ensures the Allowance for Doubtful Accounts reaches its calculated target balance.

Recording Bad Debts Expense

After calculating the bad debts expense, the amount is recorded through a journal entry. This entry involves debiting the Bad Debts Expense account and crediting the Allowance for Doubtful Accounts. For example, if the calculated bad debts expense is $11,000, the entry would be a debit to Bad Debts Expense for $11,000 and a credit to Allowance for Doubtful Accounts for $11,000. This entry impacts the income statement by recognizing the expense and adjusts the balance sheet by increasing the allowance.

The Allowance for Doubtful Accounts serves as a contra-asset account, reducing the gross amount of accounts receivable to its net realizable value. Net realizable value is the amount a company expects to collect. By increasing this allowance, financial statements present a more realistic valuation of the company’s assets. This approach ensures assets are not overstated, providing a more accurate representation of financial position.

When specific customer accounts are deemed uncollectible and written off, a separate journal entry is made. This entry involves debiting the Allowance for Doubtful Accounts and crediting Accounts Receivable for the amount being written off. For instance, if a $500 customer account is uncollectible, the Allowance for Doubtful Accounts is debited for $500, and Accounts Receivable is credited for $500. This write-off reduces both the Allowance for Doubtful Accounts and the Accounts Receivable balance. This entry does not directly impact the Bad Debts Expense account, as the expense was recognized when the allowance was established.