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What Are Doubtful Accounts and How to Minimize Them?

23 February, 2022
5 min read
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What you'll learn

  • Learn the importance of identifying doubtful accounts and how they come into existence.
  • Understand the various ways doubtful accounts seep into your collections process.
  • Discover the methods to predict and eradicate doubtful accounts.
What are doubtful accounts?
How do doubtful accounts affect your collection process?
How to identify doubtful debts?
What can you do to minimize the number of doubtful accounts?
To sum it up
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Feature image of doubtful accounts

Imagine being a collector and coming across an account you know would probably turn into an uncollectible account. But it hasn’t become a bad account, which means you can’t write it off as one. What will you do in such a scenario? Is there a way to predict or prevent unpredictable accounts (in terms of payment) from occurring? If you continue to offer goods or services to such accounts, it is possible that you have a flawed collections process.

This blog is about understanding what causes doubtful accounts and the various ways in which they could affect your collections. We’ll also look at some remedial measures to forecast and minimize the number of doubtful accounts in your AR process.

What are doubtful accounts?

A doubtful account is an account that owes you payment, but you are not sure your business is going to get paid. In other words, it’s the debt that you may have to write off and bear the losses for.

Businesses have doubtful accounts due to various reasons such as

  • Unsatisfactory Service: A customer, who is dissatisfied with the standard of your products, services, or supplies, might raise a dispute over it and decide to hold off the payment until the issue is resolved.
  • Financial Crisis: A customer might go into a financial crunch and declare insolvency or bankruptcy.

How do doubtful accounts affect your collection process?

Doubtful accounts might be much less in number than bad debt accounts, but treating them as non-essential will impact your business negatively.

Doubtful accounts that have the potential to turn into bad debt will affect the cash flow foundation of your business. In turn, it will affect your profitability, delay investment plans, and so on. When your business continuously ignores doubtful accounts, it can even result in dire consequences.

How to identify doubtful debts?

It is essential to analyze which doubtful account will turn into bad debt. Let’s look at some ways to do it:

1. Historical data analysis

It involves going through your past account receivables statistics to figure out a percentage for doubtful debt.

Formula of calculating allowance for doubtful accounts

Suppose you have $200,000 in account receivables in a specific financial period but lose $10,000 to a doubtful debt; you could set the allowance for the doubtful debt at 5% of the total AR for that period.

2. Aging method

A technique used to determine how much of a company’s accounts receivables are past due. The aging method sorts each customer’s unpaid invoices by invoice date into four columns:

  • List invoice amounts that are 0-30 days past due in the first column
  • In the second column list the invoice amounts that are 31-60 days past due
  • The next column should have invoices 61-90 days past due
  • The last column lists the invoice amounts that are 91-120 days past due
Different aging buckets to determine how much of a company's accounts receivables are past due

Assume that a company has $300,000 in accounts receivable. $120,000 of this falls into the 0-30 days bucket, $95,000 is in the 31-60 days category, $55,000 is in the 61-90 days range, and the remaining $30,000 is in the 90-120 days bucket.
From historical experience, the company accountant applies an estimated 4% doubtful debt percentage to the 0-30 days bucket, a 7% rate to the 31-60 days bucket, a 15% rate to the 61-90 days bucket, and a 20% rate to the 91-120 days bucket.
The following formula could be used to determine the amount of doubtful debt for each bucket:

Doubtful debt formula for specific time bucket

Calculating the doubtful debt for 0-30 bucket, we get:
4/100 x $120,000 = $4,800
So the doubtful debt for the 0-30 bucket is $4,800. Similarly,

  • $6,650 doubtful debt falls under the 31-60 days bucket
  • In the 61-90 range, the doubtful debt is $8,250, and
  • $6,000 of debt in the 91-120 range

This application of the aging method results in an estimated doubtful accounts receivable amount of $25,700.

3. Risk assessment

Another method to determine doubtful accounts is risk assessment. It is explicitly for businesses that deal with a small number of customers and evaluate them individually to determine the risk. Customers are divided into three risk categories: high, medium, and low. According to the level of risk, each group is assigned a percentage of the doubtful debt. The projected tolerance is calculated by multiplying these percentages by the total sales of each category.

For example, Christine works as an accountant for a business, and she wants to segregate six of her long-time customers- A, B, C, D, E, and F, based on the risk they pose. While going through historical data, she found out that:

  • A has turned about 5% of AR into doubtful debt
  • About 8% of B’s AR has turned into doubtful debt
  • C has approximately 3% of its AR converted
  • Doubtful debt conversion rate for D stands at about 15%
  • Conversion rate for E is about 12%
  • About 9% of F’s AR morphed into doubtful debt

Christine can now put the six customers in three different risk categories based on each customer’s estimated doubtful debt conversion rate.

(10% OR MORE)
(6% TO 9%)
(1% TO 5%)
D and E B and F A and C

Now, the estimate for doubtful debt could be calculated as follows. Suppose $100,000 is to be collected from all these customers. Based on this risk assessment, you could predict how much of it will turn into doubtful debt. After calculating, you get:

  • Low-risk category customers can expect an estimated loss of about $1,000–$5,000 as doubtful debt
  • $6,000–$9,000 loss can be forecasted as doubtful debt for medium-risk category customers
  • Amount lost as doubtful debt stands at $10,000 or more for the high-risk category customers

This method is not recommended for enterprises because it is difficult to segregate newly onboarded customers into a specific risk category. The fewer the customers, the more effective this process becomes.

What can you do to minimize the number of doubtful accounts?

Now that you understand how doubtful accounts impact your business, you should also be aware of the practices that could reduce them. Here’s what you need to do.

Financial health checks of your customer

An in-depth survey of the customers’ financial metrics such as liquidity, solvency, profitability, and operating efficiency would help predict their long-term economic sustainability. By doing a credit risk assessment of your prospects, you can be sure that you are working with dependable customers. Running monthly credit assessments of your present clients could be beneficial.

It’s also critical to build good ties with your consumers so that you may efficiently pursue payment. In this case, your sales team might play a key role in establishing a positive relationship.

Automate your accounts receivable processes completely

A reliable AR solution not only helps you predict and track doubtful accounts precisely but also offers statistical data to show how many doubtful accounts you could sustain without financial loss. To deal with late payments, you need to have appropriate processes and policies in place. It’s easier for your consumers to pay you on time if you allow online payments and deliver invoices and reminders promptly. If you do run into late payers, make sure you have a mechanism to deal with such instances without wasting too many resources.

To sum it up

Doubtful accounts, though fewer in number, could turn out to be harmful because they have the potential to affect AR due to their volatile nature. Tackling this is a difficult challenge in itself.
With a reliable AR solution, you get a thorough understanding of a customer, enough to predict the risk of them turning into a doubtful account. Also, you get a well-toned strategy to structure and ensure a smooth cash flow.
Automate your doubtful debt predictions and increase your collections with the RadiusOne eInvoicing & Collections App. HighRadius RadiusOne AR Suite supports AR processing for midsized companies across industries with a complete order-to-cash solution.

Reduce Bad-debt and Improve Cash Flow with AR Automation.

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