What are some of the ways to estimate bad debts?
Some of the popular ways of estimating bad debts are – the percentage of outstanding accounts, aging analysis, and percentage of credit sales.
Don’t forget to provide good examples for this accounting related question to give your recruiter the idea that you actually know the subject in depth.
Here are some more important aspects to you must remember while answering this question.
Elaborate on how each method works and the rationale behind using it.
Describe the importance of estimating bad debts accurately to reflect a more realistic financial position and facilitate sound decision-making.
Sample Answer :
“While there are many other ways to estimate bad debts, here are the ones I know.
Percentage of Outstanding Accounts Method : The percentage of outstanding accounts method estimates bad debts by applying a predetermined bad debt percentage to the total outstanding accounts receivable balance. This percentage is typically based on historical data or industry standards. The formula used is:
Bad Debts Estimate = Outstanding Accounts Receivable Balance * Bad Debt Percentage
This method considers the entire balance of outstanding accounts, regardless of the age of individual receivables. While it offers a straightforward approach, it assumes a uniform risk of default across all accounts.
Aging Analysis Method : The aging analysis method categorises accounts receivable based on the length of time they have been outstanding. It then applies different bad debt percentages to each age category, reflecting the likelihood of collection for older accounts. The formula used for each category is:
Bad Debts Estimate for an Age Category = Outstanding Receivables in the Category * Bad Debt Percentage for the Category
This method provides a more nuanced estimation, considering the specific age of each receivable. Older accounts are assigned higher bad debt percentages, recognizing the increased risk of non-payment as debts age.
Percentage of Credit Sales Method : The percentage of credit sales method estimates bad debts by applying a predetermined bad debt percentage to the total credit sales made during a specific period. The formula used is:
Bad Debts Estimate = Total Credit Sales * Bad Debt Percentage
This method links the estimation of bad debts to the volume of credit sales, assuming that a certain proportion of credit sales will eventually become uncollectible.”
