How to Use the Percentage of Sales Method

The primary objective of GAAP is to provide reliable financial information that can be used by investors, creditors, and other stakeholders to make informed decisions. You can use any method to record bad debt, as long as you remain consistent from year to year (and disclose that you’ve changed methods if that’s the case). Customers’ likelihood to short pay or skip paying altogether is deeply related to how you communicate with them throughout the billing and payment cycle. As we’ll discuss later, improving your customers’ experience is critical for minimizing bad debt. Let’s percentage of sales method assume that a company called Larry’s Lumber sells a shipment of wood to a company called Terri’s Toys, which uses the materials to create its products. This contra-asset account reduces the accounts receivable account when both balances are listed in the balance sheet.

• Here are some things I suggest you consider before relying on this model.
• These are typically accounts receivable that have been outstanding for an extended period, and after exhaustive efforts to collect, the company concludes that these debts will not be paid.
• Understanding your bad debt expenses allows your business to plan ahead, determine lost income, and help prevent cash flow issues.
• The basic idea behind the formula is to precisely find what percentage an individual account represents of your total sales.
• Do remember the matching principle if you are using the allowance method.
• At the end of the year, you calculate how much bad debt you wrote off – that’s it!

Advantages and Limitations of Percentage Forecasting Methods

You can even run a free trial on your services or promise a money-back guarantee if they aren’t satisfied with your product. Determine the balances of the line items and calculate their percentages relative to your sales. Following a few simple steps, you can forecast future revenues and expenses to ensure your business stays on track. It lets you look at past sales to make smart predictions recording transactions for the future.

Solved Calculations

By consistently tracking bad debt expense, you not only protect your cash flow and liquidity but also optimize your receivables process, ensuring a healthier financial future for your business. Adhering to GAAP in estimating uncollectible accounts is fundamental to achieving accurate, reliable, and transparent financial reporting. By following GAAP guidelines, companies can ensure compliance, enhance comparability, and maintain the trust of their stakeholders. Learn how Versapay’s collaborative AR software minimizes your company’s bad debt expenses by streamlining collections and avoiding miscommunications that often lead to late payments. The accounts receivable aging method offers an advantage because it gives AR teams a more exact basis for estimating their uncollectibles. There are two ways to record bad debt expenses in your accounting statements.

• Conduct customer surveys on how satisfied they are with your product or service.
• Say you’re hosting a party and you want to work out how many refreshments you’ll need based on when you’ve hosted before.
• The percentage-of-sales method is a financial forecasting model that assesses a company’s financial future by making financial forecasts based on monthly sales revenue and current sales data.
• With a revenue of $60,000, she’s not running a corporation, but she should still expect to run into a small amount of bad debt expense.
• Say Jim runs a retail running shoe store, and has the following line items he wants to forecast.
• Read our ultimate guide on white space analysis, its benefits, and how it can uncover new opportunities for your business today.
• You look at the historical cost of goods as a percentage of its sales and use that figure for the forecasted sales.

Discuss Common Difficulties in Accurately Estimating Uncollectible Accounts

It creates greater efficiencies, accelerates cash flow, and drastically improves the customer experience. Here’s an example of an AR aging report with collection probabilities that add up to a total bad debt reserve. It’s also worth noting that your historical percentage of collections will likely vary between bullish and bearish economic cycles. If your company has enough business history to reference how collections performed in different economic cycles, this can be helpful for casting predictions.

GAAP Requirements for Estimating Uncollectible Accounts

We’ll also show you a real-life example, highlighting its benefits and drawbacks. Enter total sales and category sales to find how much each product contributes. It helps you figure out how much of your total sales is spent on specific expenses or represents specific items. With a revenue of $60,000, she’s not running a corporation, but she should still expect to run into a small amount of bad debt expense. By looking over her records, she finds that for the month, her credit purchases come to $55,000 (with $5,000 cash).

This entry recognizes the estimated uncollectible accounts as an expense on the income statement and establishes the allowance on the balance sheet. The Direct Write-Off Method is an alternative approach to accounting for uncollectible accounts, wherein bad debts are recognized only when they are deemed definitively uncollectible. Under this method, no allowance for doubtful accounts is created; instead, the specific accounts receivable that are identified as uncollectible are directly written off against income. Accounts receivable is a permanent asset account (a balance sheet item) while sales is a revenue account (an income statement item) that resets every year. As a result, the steps you’ll take to estimate your AFDA in this method are different compared to the percentage of sales method.

• This information can be obtained from the company’s sales records, invoices, or sales reports.
• Learn how to use the sales revenue formula so you can gauge your company’s continued viability and forecast more accurately.
• Whether you’re analyzing sales performance, product contribution, or revenue breakdown—this tool is a must-have.
• Lenders and businesses that expect a portion of their receivables to go unpaid are better off using the allowance method.
• The result of your calculation in the percentage of sales method is your adjustment to the AFDA balance.
• Bad debts are categorized as an expense under your Sales, General, and Administrative (SG&A) expenses on a balance sheet.
• Your bad debts should be listed on the debit (Dr.) side of your profit & loss statement since they’re a loss for the business.

For example, purchase discounts may be applied to purchases once a unit count passes, say, 10,000 per year. The cost is variable and changes to a different percentage of sales in response to a different volume level. Your overall financial planning Debt to Asset Ratio process will consequently become even more precise and strategically valuable, offering a better percentage outlook, especially for accounts receivable.