The matching principle of accounting requires companies to report income and related expenses in the same accounting period. That is why many financial accounting standards, such as US GAAP and IFRS, require companies to apply the bad debts allowance method, which involves estimating bad debts at the end of each accounting period. The estimation can be done in a few ways, one of which is the bad debt expense as percentage of sales method.
This method uses past collection data to estimate the percentage of uncollectable credit sales. Typically, this data is from the last three years. If a business has operated for less than three years, all the available data is used. To obtain the amount of bad debts expense under bad debts expense as percentage of sales method, we simply have to multiply the amount of credit sales in the current accounting period by a percentage estimation of uncollectable sales.
The percentage estimation of uncollectable sales can be performed in two steps.
Step 1. Obtain data of credit sales and uncollected accounts receivable amount for at least the last three years (if available).
Step 2. Divide the uncollected accounts receivable amount by credit sales.
|% of Uncollectable Sales =||Uncollected Accounts Receivable Amount||× 100%|
Now we can estimate bad debt expense as percentage of sales as follows:
Bad Debts Expense = Credit Sales × % of Uncollectable Sales
The data of credit sales and uncollectable accounts receivable amount of RetailX LTD are presented in the table below.
The percentage of uncollectable sales during the last three years is 2.50%.
|% of Uncollectable Sales =||$180,430||× 100% = 2.50%|
Let’s assume that credit sales of RetailX LTD in the financial quarter ended 03/31/20X9 amounted to $730,000, and the company estimated the percentage of uncollectable sales as 2.50%. Now we can estimate the bad debts expense as a percentage of sales using the formula above.
Bad Debt Expense = $730,000 × 2.50% = $18,250
At the end of accounting period, RetailX LTD should record the adjusting entry in the general journal.
The $18,250 will increase the balance of Allowance for Doubtful Accounts.