How is an allowance for doubtful debts account typically set up?

The allowance for doubtful debts account is typically established as a percentage of the final debtors balance. This method reflects the realistic expectation of collection based on historical data and the nature of the receivable accounts. Companies analyze past experiences with uncollectable debts to determine an appropriate percentage that will cover anticipated losses in the receivables.

Using this approach allows for a more accurate representation of the financial position, as it systematically estimates the probable losses on accounts receivable without needing to know exactly which specific debts may become uncollectible. This aligns with the accrual accounting principle, ensuring that expenses (in this case, bad debts) are matched with the revenues they relate to in the accurate reporting of net income.

The other methods listed may not provide the same balance of accuracy and reliability. For instance, basing the allowance strictly on total sales does not take into account the actual debtors' balances or the unique risks associated with certain customers. Similarly, setting a fixed amount determined by management lacks the adaptability needed when dealing with fluctuating economic conditions and customer reliability. Averaging past bad debt losses might not always reflect current trends or changes in customer creditworthiness, and can therefore result in over- or underestimating the allowance needed.