When forecasting their company’s future earnings potential, many small business owners forget to estimate the amount of their credit sales that will never be collected. Since the point of forecasting is to identify future financial problems, disregarding bad debt can significantly overestimate expectations of future cash reserves and financial security. Understanding and tracking a company’s bad debt expense can lead to more efficient collection efforts and more stable income. The goal of every small business owner should be to enhance business credibility, which starts with maintaining stabile and consistent cash flows.
The estimate of the company’s credit sales that the company assumes that it will not be able to collect in a period is commonly known as the “Allowance for Doubtful Accounts”. Every time an invoice is deemed uncollectible the obligation is written off and is deducted from cash flow as a “bad debt expense”. At the end of the period the total of the bad debt expense makes up the allowance for doubtful accounts and is deducted from the company’s accounts receivables to give analysts or creditors a realistic picture of the receivables they can turn into cash.
At some point all companies will have customers that, for whatever reason, will not pay the total value of the goods and services they bought on credit. This business allowance for doubtful accounts, also known as the bad debt reserve or simply bad debt, reduces the company’s accounts receivable balance to reflect the amount the company feels it will likely have to write off. Subtracting bad debt from the receivable asset on the balance sheet gives the reader a clearer more truthful picture of the company’s financial situation. Without considering this business allowance the company might overestimate the money of cash reserves it could collect and spend should the need arise. Instead of having to reflect the write off of every single write off when it happens, the accrual basis of accounting provides an estimate of what this amount will likely be for the period and then adjusts the balance for what actually happened. Since owners and investors do not like having any surprises, especially negative financial information, the business allowance for doubtful accounts helps increase the probability that the company’s earnings will be closer to what was expected during the period.
A simple way to estimate the business allowance is to derive an uncollectible or write off rate from the previous year’s credit sales and use that rate against the expected credit sales for the next year. The rate is calculated by taking the previous year’s bad debt expense and dividing it by credit sales for the same period. By dividing the bad debt expense by the credit sales you derive the percentage of credit sales that needed to be written off. By multiplying that rate times the estimate for credit sales in the next year, you will determine the total bad debt expense or doubtful accounts balance for the year.
For example, if you had a company that sold $1 million of goods on credit last year and of those sales $15,000 had to be written off as uncollectible, you would have had an uncollectible rate of 1.5%. 1. 5% is calculated by dividing the bad debt expense of$15,000 by $1,000,000. Let us say that next year you assume that total credit sales will increase to $1.3 million. Since the bad debt expense for the previous year was 1.5%, you could take that same rate against the projected credit sales of $1.3 million to forecast write-offs for the next year to be $19,500 ($1,300,000 x .015). At the beginning of the year the business allowance for doubtful accounts would be $19,500. That amount would be reduced over time as certain invoices were written off as uncollectible. If the estimate for bad debt expense was perfect, the balance for doubtful accounts would be zero after the last invoice was written off at the end of the year.
Since it is a forecast, the amount of the doubtful account that is kept on the balance sheet will be a function of how conservative or liberal management is when estimating it. Although bad debt will reduce taxable income and the income tax expense, the IRS does not allow companies to write off their account estimate, only the actual invoices written off as uncollectible. For this reason there is no benefit of being overly conservative or liberal when estimating the allowance for doubtful accounts at the beginning of the period.
The purpose of the business allowance is to reduce surprises in the financial statements and to reflect an accurate picture of the company’s financial health. It is a management tool for the company and any of its stakeholders, such as vendors or creditors, to get a good understanding of how the company operates and to identify any potential business risks. Management should endeavor to estimate the level of these uncollectible amounts well in advance of having to write them off. Painting a truthful picture of the company’s potential future earnings goes a long way in enhancing a firm’s market reputation and credibility with all of its partners.