How to estimate uncollectible receivables

What are Uncollectible Receivables?

Uncollectible receivables are trade accounts receivable that are very unlikely to be paid by the customer. This is usually evidenced by a long period having lapsed since an invoice was issued, and/or indications from the customer that it has not intention of paying.

Why Estimate Uncollectible Receivables?

The amount of uncollectible accounts receivable must be estimated in order to create an allowance for doubtful accounts. The allowance for doubtful accounts contains the accountant’s best estimate of the proportion of receivables currently outstanding that will not be paid.

This estimate can be derived from the aged accounts receivable report, or by using a percentage of sales. Both approaches are described next. This estimate is used in an accrual-basis business where reserves are set up in contra accounts to be paired with and offset various asset accounts.

Derivation from an Aging Analysis

A common estimation method is based on the aged accounts receivable report. This report categorizes unpaid customer invoices by time bucket. Each time bucket is usually in 30-day increments, so the 31-60 day bucket, the 61-90 day bucket, and the 90+ day bucket show those invoices with increasing probabilities of nonpayment. The accountant assigns a larger percentage of assumed nonpayment probability to each of these time buckets, such as 5% to the balance in the 31-60 day bucket, 20% to the 61-90 day bucket, and 40% to the 90+ day bucket. These percentages are based on the historical experience of the firm in obtaining payments from each of these classifications. The totals of estimated unpaid amounts for each time bucket are then added together to arrive at the total amount of estimated uncollectible receivables. This approach works best when receivables include a small number of relatively large invoices.

Example of How to Estimate Uncollectible Receivables

An accountant has an accounts receivable aging report that itemizes $1,000,000 of trade accounts receivable. The report separates the receivables into 30-day time buckets, where $700,000 is in the 0-30 days time bucket, $250,000 is in the 31-60 days time bucket, and the remaining $50,000 is in the 61-90 days time bucket. Historically, the company has experienced a loss rate of 2% of the receivables in its 0-30 days time bucket, 5% in its 31-60 days time bucket, and 20% in its 61-90 days time bucket. The calculation of the estimated uncollectible receivables in this aging report is as follows:

($700,000 x 2%) + ($250,000 x 5%) + ($50,000 X 20%) = Estimated uncollectible receivables

$14,000 + $12,500 + $10,000 = $36,500 Estimated uncollectible receivables

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Derivation from Total Sales

A simpler approach is to assume that a percentage of total credit sales will not be collected. This percentage, which is based on historical experience, is multiplied by total credit sales. Thus, if the historical experience is a 0.5% bad debt rate, then this amount is applied to total credit sales. This approach is not as refined as a derivation from the aged receivables report, but can be adequate when sales are comprised of many small invoices.

Accounting for Uncollectible Receivables

No matter which method is used, the resulting estimate is added to the allowance for doubtful accounts by debiting the bad debt expense account and crediting the allowance for doubtful accounts.