It may here be noted that when making up the estimate of bad debts it is by no means always necessary to analyze the outstanding items as suggested above. Such an analysis is of value in three cases:
1. In the case of a new concern where there is no past experience on which to base the estimate.
2. In the case of an outsider—a professional auditor or other party—being called upon to make the estimate.
3. Periodically, in any business, as a check on the work of the collection department.
The value of the analysis in cases (1) and (2) is based on the principle that the longer an item is overdue, the greater is its likelihood of proving uncollectible. The need of an increasing rate for the different classes as analyzed above is apparent. In case (3) its value lies in the fact that it reveals the general effect of the collection policy and incidentally points out any change in policy. Any additional factors which may have wrought a change in the general financial situation must, of course, be taken into account.
Basis of Estimate of Bad Debts
Three methods of making an estimate of bad debts are found, in all of which a percentage of some given base is used. The various bases are respectively:
1. The amount of outstanding trade debt at the time of the balance sheet.
2. The amount of sales on credit made during the present fiscal period.
3. The total sales, both cash and credit, for the present period.