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The problem with some methods of estimating how much of the accounts receivable will go bad is that they treat all debts as equal.
All debts are rarely equal.
It turns out that the longer a debt has gone unpaid, the more likely it will never be paid.
- Some customers fall on hard financial times.
- Some customers become difficult to reach.
- Some customers realize that nothing bad happened to them when they didn't pay earlier.
As a result, many firms treat older debt as less likely to be collected.
These firms will break debts into pools, with pools of older debt being valued significantly less than younger pools.
To calculate the estimated uncollectable value of a pool, one must take the face value of a pool and then multiply it by it estimated percentage of uncollectable debt.
When this calculation is performed for every pool, and the result summed, the firm will possess a fairly accurate prediction of how much of its receivables it can expect to have write off.
It is absolutely essential to remember that the allowance for doubtful accounts, which is an estimate of how much debt will need to be wrtten off, is a contra-asset. This means that any reserves for future write-offs will be on the credit side.