In this post, we’ll go through an illustration to understand the mechanism of calculating allowance for bad debts.
Step 1 – Calculation of historical default rate
XYZ Company has selected two years 20X1 and 20X2 to evaluate its credit sales. Purpose of this analysis is to calculate the historical default rate based on the actual credit loss pattern in these two years. Following is the analysis of credit sales of financial year ended 31 December 20X1.
Although the credit loss occurred when the receivable balance was more than 360 days old, however, it passed through all the previous age brackets over its life. Initially it was in 1-45 days age bracket when the credit sale was made. After 45 days, it was shifted to the next age bracket and so on. Therefore, the credit loss is applied to all the age brackets.
For instance, historical default rate of 8.8% of age bracket 1-45 days means that historically, 8.8% of the receivables in this age bracket defaulted. Same theory applies to all the age brackets.
Now, let’s move on towards incorporating the forward-looking information.