Q5: What are two ways we can estimate bad debts when using the allowance method?
We can make estimate a firm’s bad debts based on the firm’s actual experience of bad debts in the past, combined with a judgement of the future economic and business conditions our customers as a group may experience in the future. For example, if we are expecting a downturn in economic conditions in our industry, or in the economy more generally, in the next few months or year we may increase our estimate of bad debts.
Approaches we can use to help us quantify these judgements include ‘Percentage of net credit sales’ (the Income statement method) and ‘Ageing of accounts receivable’ (the Balance sheet method).
Percentage of net credit sales (the Income statement method)
Businesses that have been operating for some time have previous experience of customers buying goods or services from them on credit and then failing to pay them. These firms can look back at their past experience to see the relationship between credit sales and bad debts that the firm has experienced in the past. For example, in the past the firm may have experienced bad debts of about 1% of its net credit sales (net of sale returns) each year. This relationship between credit sales and bad debts can vary between different industries as well as between firms in the same industry.
Ageing of accounts receivable (the Balance sheet method)
Another approach to help us quantify our judgements concerning estimating bad debts in a period is ‘Ageing of accounts receivable’. This is similar to the ‘Percentage of net credit sales’ approach with the added element that we seek to identify a relationship between how long the Accounts receivable from our customer is outstanding and its likelihood of never being paid (rather than to simply rely on the relationship between credit sales in total). This approach is based on the idea that the longer a debt from a customer remains unpaid the greater is the risk that the customer may never pay us what they owe us.