It is very normal for many customers to make late payments on the goods and services they are provided with, and there are also a few who never bother to pay at all. In many businesses, buyers allow their customers to make purchases on a product on credit – which means the customers get an invoice upon receiving the product, and they can pay for it within a set time period. This is risky, and some customers may end up not paying for the product, or pay a small amount of the entire payment. These are default payments, where the payment is made of only the amount they owe to the buyer, excluding the rest. These are termed as doubtful accounts in the business world as sellers have to recognize the defaults as expenses then, and they have to maintain an allowance for the default. The allowance for the doubtful account is calculated as follows:
- All the information on the accounts is gathered. The business’s current and it’s historical accounts receivable records are collected.
- Since the allowance of the doubtful account is calculated to draw out future payments, it is not a direct calculation, but rather, it is an estimation of the future defaults. To estimate the expense, different ways are looked into – with a percentage of the total sales, with the individual risk analysis, and a combination of both. The best method is chosen that matches the customer base.
- If the business is large and progressive, a percentage of the total sale is taken. This is done by an examination of the historical records and the unpaid sale accounts. Then, the value of the unpaid accounts is divided by the total sales figures to give a percentage of the total sales that are unpaid. The percentage is then applied to the current sales figures.
- If the business has less customers, an individual risk analysis is take of each customer. In this, the clients are organized into categories based on the historical risk of the unpaid accounts. A percentage is placed on each category then, and multiplied by the total sales to get an estimated allowance for the doubtful account.