Allowance for Bad Debts

April 13, 2006

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The purpose of making an allowance for bad debts is to try to guess the total amount of bad debts that you're likely to incur during the tax year. You do this by calculating the bad debts as a percentage of your sales.

But which percentage should you use? If you've been in business for a few years, you can look at your own experiences to determine a percentage.

The McGoverniks Company has been in business for three years. In those three years, it has experienced the following:

	Sales	Bad debts	% of sales
Year 1	$16,000	$480	3.0
Year 2	$22,000	$120	0.5
Year 3	$26,000	$360	1.38
Totals	$64,000	$960	1.5
In Year 4, the ABC Company should use 1.5 percent as its bad debt allowance.

If you're just starting out, you'll just have to make a guess. Start out with something around 1.5 percent or 2 percent, and adjust it in the following years as your actual experience dictates.

For details on how the actual book entries would be made, see adjusting for bad debts.