What are the two methods of estimating uncollectible accounts?

The two primary methods for estimating uncollectible accounts are the percentage of sales method and the accounts receivable aging method. These two approaches are widely used by businesses to accurately reflect the true value of their outstanding receivables and to properly account for potential losses from customers who may not pay their debts.

Understanding Uncollectible Accounts

When businesses sell goods or services on credit, they create accounts receivable—money owed to them by customers. However, not all of these debts will be collected. Accounts that are unlikely to be recovered are known as uncollectible accounts or bad debts. Accurately estimating these uncollectible amounts is crucial for financial reporting, as it impacts a company's profitability and the reported value of its assets.

To maintain accurate financial records and present a realistic view of a company's financial health, businesses must estimate and account for these potential losses. This estimation typically involves one of two common methods, each with a distinct focus.

Methods for Estimating Uncollectible Accounts

The two most common ways to estimate uncollectible accounts are the percentage of sales method and the accounts receivable aging method.

1. Percentage of Sales Method

The percentage of sales method, also known as the income statement approach, estimates uncollectible accounts based on a specific percentage of a company's credit sales for a given period. This method focuses on matching bad debt expense to the sales that generated the receivables in the same accounting period, aligning with the matching principle of accounting.

• How it Works: A historical percentage of uncollectible sales is applied to the current period's net credit sales. For example, if a company historically estimates 2% of its credit sales become uncollectible, and it has $500,000 in credit sales, the estimated bad debt expense would be $10,000 ($500,000 * 0.02).
• Focus: This method primarily focuses on determining the bad debt expense to be recognized on the income statement.
• Practical Insight: It is simpler to apply, as it only requires sales data and a determined percentage. However, it might not always accurately reflect the current collectibility of specific receivables.
• Learn More: For a deeper dive, explore resources on the percentage of sales method.

2. Accounts Receivable Aging Method

The accounts receivable aging method, often called the balance sheet approach, estimates uncollectible accounts by analyzing the age of individual accounts receivable balances. This method provides a more detailed and generally more accurate estimate of the uncollectible portion of accounts receivable.

• How it Works: Accounts receivable are categorized into age brackets (e.g., 1-30 days, 31-60 days, 61-90 days, over 90 days). A higher percentage of uncollectibility is typically assigned to older, past-due accounts, as they are less likely to be collected. The estimated uncollectible amount for each category is then summed to arrive at the total estimated uncollectible amount for the allowance for doubtful accounts.

  Example Aging Schedule:

  Age of Receivable	Balance Due	Estimated Uncollectible %	Estimated Uncollectible Amount
  1-30 days	$100,000	1%	$1,000
  31-60 days	$50,000	5%	$2,500
  61-90 days	$20,000	15%	$3,000
  Over 90 days	$10,000	40%	$4,000
  Total	$180,000		$10,500

  In this example, $10,500 would be the desired balance in the Allowance for Doubtful Accounts. The bad debt expense for the period would be the amount needed to bring the allowance to this balance.

• Focus: This method focuses on valuing the net realizable value of accounts receivable on the balance sheet.

• Practical Insight: While more complex to implement, it provides a more granular and often more reliable estimate because it considers the specific risk associated with the age of each outstanding account. It directly aims to ensure the Allowance for Doubtful Accounts reflects the uncollectible portion of receivables at the balance sheet date.

• Learn More: For more information, refer to resources on the accounts receivable aging method.

Comparison of Methods

Choosing between these methods often depends on a company's size, complexity, and desired level of accuracy.