By: Flaka Ismaili    June 30, 2023

The balance sheet method (also known as the
percentage of accounts receivable method) estimates bad debt
expenses based on the balance in accounts receivable. The method
looks at the balance of accounts receivable at the end of the
period and assumes that a certain amount will not be collected. Accounts receivable is reported on the balance sheet; thus, it is
called the balance sheet method. The balance sheet method is
another simple method for calculating bad debt, but it too does not
consider how long a debt has been outstanding and the role that
plays in debt recovery.

• And the fed rate climbed over 2023, and when that happens, that can affect the interest rate on consumer products like credit cards.
• It’ll help keep your books balanced and give you realistic insight into your company’s accounts, allowing you to make better financial decisions.
• These differences show that management can choose from various methods when applying generally accepted accounting principles and that these choices influence the firm’s financial statements.
• While applying the aging method, keep in mind that other factors can impact the accuracy of your estimation.
• So there’s some protection for credit scores there, but the thing with that is that interest is still going to accrue during the period, and the amount you owe will go up if you’re not making payments.
• For example, when companies account for bad debt expenses in their financial statements, they will use an accrual-based method; however, they are required to use the direct write-off method on their income tax returns.

The net of these two account balances is the expected amount of cash that will be received from accounts receivable. The aging method is used because it helps managers analyze individual accounts. This provides information which can be used to determine whether any further collection efforts are justified or not. The aging method also makes it easier for management to make changes in credit policies and discounts offered to customers. These differences show that management can choose from various methods when applying generally accepted accounting principles and that these choices influence the firm’s financial statements. The method used to estimate the desired balance in the allowance account is called the aging of accounts receivable.

Why bad debts happen

When the estimation is recorded at the end of a period, the following entry occurs. The understanding is that the couple will make payments each month toward the principal borrowed, plus interest. Businesses that use cash accounting principles never recorded the amount as incoming revenue to begin with, so you wouldn’t need to undo expected revenue when an outstanding payment becomes bad debt.

• That journal entry assumed a zero balance
  in Allowance for Doubtful Accounts from the prior period.
• Under the direct write-off method, bad debt expense serves as a direct loss from uncollectibles, which ultimately goes against revenues, lowering your net income.
• For many different reasons, a company may be entitled to receiving money for a credit sale but may never actually receive those funds.
• On the balance sheet, the Allowance account will reflect the desired balance once the account balance is updated with the journal entry.
• So Lauren, it’s always important to pay attention to how you’re managing your credit card debt, but even more so in this high interest rate environment, right?
• The project is completed; however, during the time between the start of the project and its completion, the customer fails to fulfill their financial obligation.

Accounting software will likely have a feature that generates the aging of accounts receivable. However, when customers are past due it is a sign that they are experiencing some financial difficulties. The greater the amount of time they are past due, accounts receivable procedures flowchart the greater the possibility they will not pay the amount they owe the company. On the assumption that the longer an account is outstanding, the less likely its ultimate collection is, an increasing percentage is applied to each of these categories.

Accounts Receivable Aging: Definition, Calculation, and Benefits

This amount becomes the desired ending balance in the Allowance for Uncollectible Accounts. This sum represents the estimated amount of accounts receivable that will become uncollectible. Sum up the individual estimations for each category to determine the total bad debt expense.

Benefits of Accounts Receivable Aging

So for people who weren’t making payments during that more than three year pause, having to budget for it again can be really tough. So there’s some protection for credit scores there, but the thing with that is that interest is still going to accrue during the period, and the amount you owe will go up if you’re not making payments. So if you want to avoid a big balance and risking missed payments once those protections go away toward the end of the year, keep paying off those loans if you’re able to, and that can keep your credit from taking a hit. So if you don’t qualify for a balance transfer or you think maybe you could pay off the balance in just a few months, there’s some other methods you can try. One is just make at least the minimum payment if possible to avoid late fees and penalties. And then you can throw any extra money you might have toward additional payments.

What Is the Typical Method for Aging Accounts?

The accounts receivable aging method groups receivable accounts based on age and assigns a percentage based on the likelihood to collect. The percentages will be estimates based on a company’s previous history of collection. The allowance method estimates bad debt expense at the end of the fiscal year, setting up a reserve account called allowance for doubtful accounts.

Example of the Aging of Accounts Receivable and Bad Debts Expense

Maybe that’s a bonus you get from work, or maybe you pause your Netflix subscription for a while and you redirect that $20 a month toward your debt. But if you have multiple debts and not just one card, you can follow either the debt avalanche or the debt snowball method to pay off what you owe. We’ll get into that in a second, but first you’ll want to list out the balance and the interest rate for each account you have. The first method, debt avalanche, is where you would make at least the minimum payments on all your debts and you’d put any extra money you have toward the debt with the highest interest rate. Then once that debt’s paid off, you move on to the next highest interest rate and so on.

So you shouldn’t see a huge hit to your credit report for that whole seven years. The detailed information in the accounts receivable subsidiary ledger is used to prepare a report known as the aging of accounts receivable. This report directs management’s attention to accounts that are slow to pay. It is also useful in determining the balance amount needed in the account Allowance for Doubtful Accounts.

You may notice that all three methods use the same accounts for the adjusting entry; only the method changes the financial outcome. Also note that it is a requirement that the estimation method be disclosed in the notes of financial statements so stakeholders can make informed decisions. Recording uncollectible debts will help keep your books balanced and give you a more accurate view of your accounts receivable balance, net income, and cash flow.

Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. For most companies, the better route is to improve their collection processes internally and implement the right procedures to reduce such occurrences. In the latter scenario, the customer might never have had the intent to pay the seller in cash. Regularly review and update your estimation percentages to ensure they remain reliable in changing economic and market conditions. While applying the aging method, keep in mind that other factors can impact the accuracy of your estimation.

Flaka Ismaili

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