The percentage of receivables method is used to derive the bad debt percentage that a business expects to experience. The technique is used to populate the allowance for doubtful accounts, which is a contract account that offsets the accounts receivable asset.
At the most basic level, the percentage of receivables method requires the following steps:
- Obtain the ending trade accounts receivable balance listed in the balance sheet.
- Calculate the historical percentage of bad debts to accounts receivable.
- Multiply the ending trade receivables balance by the historical bad debt percentage to arrive at the amount of bad debt to be expected from the ending receivables balance.
- Compare this expected amount to the ending balance in the allowance for doubtful accounts, and adjust the allowance as necessary for it to match the latest calculation.
A problem with the preceding calculation is that it may not be sufficiently refined; it does not account for different ages of accounts receivable, only the grand total of all receivables. A better approach is to print an aged accounts receivable report as of the end of the reporting period that contains 30-day time buckets, and apply the historical bad debt percentage for each time bucket to the bucket totals in the report. For example, the loss rate for current receivables may be only 1%, while the loss rate for receivables older than 90 days may be 50%.
Another issue is to not use an excessively long time period to derive the historical bad debt percentage, since changes in the economic environment may have altered the loss rate. Instead, consider using the historical loss rate for the past 12 months on a rolling basis.