Determine Net Accounts Receivable

Accounts receivable is a concept used in accounting to indicate payments due to a business. When a business sells its product on credit, the customer is invoiced and then given a set time period (often 30 days) to pay. This payment model carries an inherent risk that the customer may default and the business will not be able to collect the money it is owed. There is always a difference between the accounts receivable balance and the portion of that balance that is actually expected to be collected, which is referred to as net accounts receivable. Therefore, an accountant should determine net accounts receivable by subtracting the so-called "allowance for doubtful accounts," which estimates the portion of total accounts that will go unpaid, from accounts receivable.

Steps

Estimate Percentage Allowance for Doubtful Accounts

  1. Gather accounts receivable documents. To account for doubtful accounts, begin with your business's current and historical accounts receivable records. These should detail the business's various customers and their order amounts, along with whether or not those customers have paid for their orders in the past.[1]
  2. Determine which estimation method to use. The allowance for doubtful accounts is recorded before the actual accounts are (or are not) paid.[1] This means that unlike your power bill or the cost of printer paper, you will not know what your actual doubtful debt expense will be. In other words, at the end of the period, you will have recorded all credit sales (sales not paid on delivery or in cash) in full, regardless of if they have been paid or not. Therefore, to record the credit sales that may not be paid for, you will have to estimate them beforehand, using one of several accounting methods.
    • There are several different ways to go about estimating this expense, including:
      • Using a percentage of total sales
      • Using individual risk analysis
      • Using a combination of the two
    • Which one is the best choice for your business depends on the makeup of your customer base. The ideal consumer base and estimation process for each method are explained in the following steps.

Choosing an Estimation Method

  1. Use a percentage of total sales. For companies with a relatively large number of smaller accounts (customers that only buy small amounts of product), or companies that historically have experienced only a very small amount of unpaid accounts, the best and easiest option is to estimate the allowance as a percentage of sales. Calculate a reasonable percentage of sales by:
    • Examining historical records of unpaid sales accounts. Look over your records and find out when sales accounts went unpaid. It's generally a good idea to look over the past five years and find out your total sales for each year and the total value of unpaid accounts for each year.
    • Finding the average percentage of total sales that this debt accounted for. For each year, divide the value of unpaid accounts by your total sales figures. This will give you a percentage of total sales that went unpaid.
    • Applying that percentage to the current sales figure. For example, if 3% of debts historically went unpaid, the company will adjust the allowance for doubtful accounts to 3% of total sales for the current accounting period.[1]
  2. Use risk analysis. If your company deals with a relatively small number of clients, use an individualized risk analysis for each customer. This requires organizing clients into categories based on historical risk of unpaid accounts. For example, some clients might be deemed high-risk, while others might be low-risk or medium-risk. Each category is then assigned a doubtful accounts percentage that reflects the likeliness of customers in that category failing to pay their accounts. Multiply these percentages by total sales in each customer category to arrive at an estimated allowance for doubtful accounts.[2]
    • This method can be more art than science. For example, you cannot assign a historical risk rate to a new customer. In this case, you can use either a historical percentage of sales for all accounts (see previous step) or you can use your own personal judgement of the customer. Additionally, a customer that has historically let his purchases go unpaid may become more reliable with time or improving business. This might be reason enough to raise his risk rating higher than a historical analysis would suggest.
    • For a more specific example, imagine a customer that has historically paid his debts every time or almost every time, perhaps only faltering once during hard times. Classify sales by this customer, and others like them, as "low-risk" and assign them a very low bad debt percentage, like 0.5%. Then, multiply this bad debt percentage by total sales in these accounts to get the bad debt expense for "low-risk" accounts.
  3. Use a combined analysis. If your company has a large amount of clients, but also a few large clients that make up a disproportionate share of total sales, consider combining the two above methods. Specifically, use the risk analysis method for the larger clients and the percentage of sales method for the smaller clients. This requires separating total sales for large clients from total sales for smaller clients, but is more accurate than simply using a historical sales percentage across the board.[3]
    • Imagine for example that you have three clients that, combined, make up 60% of your total sales. All of these clients are in good standing and almost always pay for your products on time. Assign these clients a low bad debt allowance percentage, like 0.5%, and multiply this number by total sales to these customers to get an estimate bad debt expense. The other 40% of your business is made up of smaller customers that only order a few products at a time. For these customers, you would examine total unpaid debts and total sales to these customers to create a historical unpaid debt percentage to use for these customers, maybe at 4% or so.
  4. Create a receivables aging schedule. This additional option is for all types of customer bases, and is a more complex process that uses historical data to determine the likelihood of payment based on how many days past due an invoice is. Essentially, decide on an average point at which very late accounts typically become uncollectible accounts and estimate your doubtful accounts by age.[4]
    • This schedule categorizes accounts as either current (not due yet), 1–30 days late, 30–60 days late, 60–90 days late, or 90 plus days late. Figuring out bad debt percentages using this process is complicated and is generally best left to accounting software, which can calculate this information accurately and quickly.[4]

Calculate Net Accounts Receivable

  1. Sum all accounts receivable. This will give you the asset account that you need for this calculation. Remember to calculate this value end of an accounting period. Accounts receivable reflects all current outstanding accounts (that haven't yet been paid by customers).[5]
    • If you did any risk categorization in your calculation of the percentage allowance for doubtful accounts, be sure to make a note of which risk level or risk category each accounts falls into. This will help you calculate the percentage allowance for doubtful debts you need to use.
  2. Calculate the allowance for doubtful accounts. Multiply your decided allowance for doubtful accounts percentage by the current value for accounts receivable to get your allowance for doubtful accounts. This number should represent the monetary value of accounts that you expect will not be paid. This should be done at the end of an accounting period.[6]
    • If you are using any form of risk categorization, remember to adjust the additional revenue doubtful account percentage based on which customer or risk category it is coming from. Essentially, you need to be able to multiply the revenue from each customer category by the risk percentage of that category, individually. This may require separating the current value for accounts receivable into categories or even into individual accounts.
    • After separating, simply multiply each account or category by the associated allowance for doubtful accounts percentage and then add then together. This will give you a total value for allowance for doubtful accounts.
    • For example, imagine that your accounts receivable total $100,000. Of this, $30,000 come from high-risk customers, $20,000 from medium-risk, and $50,000 from low-risk, with allowance for doubtful debt percentages of 5%, 2%, and 1%, respectively. Your total allowance for doubtful debts would be ($30,000*0.05) + ($20,000*0.02) + ($50,000*0.01), or $2,400.
  3. Subtract your allowance for doubtful accounts from accounts receivable. This will give you your value for net realizable receivables. This is your total amount of receivables that you expect to actually collect.[7]
    • Continuing with the previous example, you would subtract the allowance for doubtful accounts of $2,400 from the total accounts receivable of $100,000 to get your net accounts receivable, which would be $97,600.
    • Remember to record allowance for doubtful debts in accordance with the matching principle. Even though this customer may very well pay in full, record the expense to match it with its corresponding revenue.[3]
    • Technically, this "subtraction" is actually an addition of a current asset account, accounts receivable, and a contra-asset account, allowance for doubtful accounts. The contra-asset account is a negative value so it reduces the asset account when added.[7] Unless you are a publicly-held company though, there is no need to strictly follow this organization. The important thing is that the subtraction is made.
  4. Find net accounts receivable as a percentage. In many case, net accounts receivable is expressed as a percentage instead of as a value. This is done by simply subtracting the percentage allowance for doubtful accounts from 100%. In this case, the percentage represents the chance that a company is able to collect money from its customers. This can serve as a measure of the health of the company.[8]
    • For example, if the forecasted percentage allowance for doubtful accounts is 3%, the net accounts receivable expressed as a percentage would be 100% - 3%= 97%. This means that 97% of customers will end up paying the company for its services or products.
    • For different risk levels, you would have to take a weighted average of the percentage allowance for doubtful accounts and use that as your overall percentage. You would then subtract this percentage from 100%, as before, to find net accounts receivable. See how to calculate weighted average for more.

Tips

  • The calculations above will also work when expressed in other currencies.

Related Articles

Sources and Citations

  1. ↑ 1.0 1.1 1.2 http://www.investopedia.com/terms/a/allowancefordoubtfulaccounts.asp
  2. ↑ http://www.accountingtools.com/bad-debt-forecast
  3. ↑ 3.0 3.1 http://www.accountingtools.com/allowance-for-doubtful-account
  4. ↑ 4.0 4.1 http://www.investopedia.com/terms/a/aging-schedule.asp
  5. ↑ http://www.investopedia.com/terms/a/accountsreceivable.asp?header_alt=false
  6. ↑ http://www.accountingcoach.com/terms/A/allowance-for-doubtful-accounts
  7. ↑ 7.0 7.1 http://www.accountingcoach.com/terms/A/accounts-receivable-net
  8. ↑ http://www.investopedia.com/terms/n/netreceivables.asp?header_alt=false
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