What Is Annualized Income?

Annualized income is an estimate of the sum of money that an individual or a business generates over a year’s time. Annualized income is calculated with less than one year’s worth of data, so it is only an approximation of total income for the year. Annualized income figures can be helpful for creating budgets and making estimated income tax payments.

Understanding Annualized Income

Annualized income can be calculated by multiplying the earned income figure by the ratio of the number of months in a year divided by the number of months for which income data is available. If, for example, a consultant earned $10,000 in January, $12,000 in February, $9,000 in March and $13,000 in April, the earned income figure for those four months totals $44,000. To annualize the consultant’s income, multiply $44,000 by 12/4 to equal $132,000.

How Estimated Tax Payments Work

Taxpayers pay annual tax liabilities through tax withholdings and by making estimated tax payments each quarter. There are many sources of income that are not subject to tax withholding. Income from self-employment, interest and dividend income and capital gains are not subject to tax withholdings, along with alimony and some other sources of income that may be reported to a taxpayer on Form 1099. To avoid a penalty for tax underpayment, the total tax withholdings and estimated tax payments must equal to the lesser of 90% of the tax owed for the current year or the full tax owed the previous year.

Examples of Annualized Income That Fluctuates

Computing estimated tax payments is difficult if the taxpayer’s income sources fluctuate during the year. Many self-employed people generate income that varies greatly from one month to the next. Assume, for example, that a self-employed salesperson earns $25,000 during the first quarter and $50,000 in the second quarter of the year. The higher income in the second quarter indicates a higher total level of income for the year, and the first quarter’s estimated tax payment is based on a lower level of income. As a result, the salesperson may be assessed an underpayment penalty for the first quarter.

Factoring in the Annualized Income Installment Method

To avoid the underpayment penalties due to fluctuating income, the IRS Form 2210 allows the taxpayer to annualize income for a particular quarter and compute the estimated tax payments based on that amount. Schedule AI of Form 2210 provides a column for each quarterly period, and the taxpayer annualizes the income for that period and computes an estimated tax payment based on that estimate. Using the salesperson example, Form 2210 allows the taxpayer to annualize the $25,000 first quarter income separately from the $50,000 second quarter income.

What is Allowance For Credit Losses?

Allowance for credit losses is an estimate of the debt that a company is unlikely to recover. It is taken from the perspective of the selling company that extends credit to its buyers.

How Allowance For Credit Losses Works

Most businesses conduct transactions with each other on credit, meaning they do not have to pay cash at the time purchases from another entity is made. The credit results in an accounts receivable on the balance sheet of the selling company. Accounts receivable is recorded as a current asset and describes the amount that is due for providing services or goods.

One of the main risks of selling goods on credit is that not all payments are guaranteed to be collected. To factor in this possibility, companies create an allowance for credit losses entry.

Since current assets by definition are expected to turn to cash within one year, a company’s balance sheet could overstate its accounts receivable and, therefore, its working capital and shareholders’ equity if any part of its accounts receivable is not collectible.

The allowance for credit losses is an accounting technique that enables companies to take these anticipated losses into consideration in its financial statements to limit overstatement of potential income. To avoid an account overstatement, a company will estimate how much of its receivables it expects will be delinquent.

Recording Allowance For Credit Losses

Since a certain amount of credit losses can be anticipated, these expected losses are included in a balance sheet contra asset account. The line item can be called allowance for credit losses, allowance for uncollectible accounts, allowance for doubtful accounts, allowance for losses on customer financing receivables or provision for doubtful accounts.

Any increase to allowance for credit losses is also recorded in the income statement as bad debt expenses. Companies may have a bad debt reserve to offset credit losses.

Allowance For Credit Losses Method

A company can use statistical modeling such as default probability to determine its expected losses to delinquent and bad debt. The statistical calculations can utilize historical data from the business as well as from the industry as a whole. 

Companies regularly make changes to the allowance for credit losses entry to correlate with the current statistical modeling allowances. When accounting for allowance for credit losses, a company does not need to know specifically which customer will not pay, nor does it need to know the exact amount. An approximate amount that is uncollectible can be used.

In its 10-K filing covering the 2018 fiscal year, Boeing Co. (BA) explained how it calculates its allowance for credit losses. The manufacturer of airplanes, rotorcraft, rockets, satellites, and missiles said it reviews customer credit ratings, published historical credit default rates for different rating categories, and multiple third-party aircraft value publications every quarter to determine which customers might not pay up what they owe.

The company also disclosed that there are no guarantees that its estimates will be correct, adding that actual losses on receivables could easily be higher or lower than forecast. In 2018, Boeing’s allowance as a percentage of gross customer financing was 0.31%.

Example of Allowance For Credit Losses

Say a company has $40,000 worth of accounts receivable on September 30. It estimates 10% of its accounts receivable will be uncollected and proceeds to create a credit entry of 10% x $40,000 = $4,000 in allowance for credit losses. In order to adjust this balance, a debit entry will be made in the bad debts expense for $4,000.

Even though the accounts receivable is not due in September, the company still has to report credit losses of $4,000 as bad debts expense in its income statement for the month. If accounts receivable is $40,000 and allowance for credit losses is $4,000, the net amount reported on the balance sheet will be $36,000.

This same process is used by banks to report uncollectible payments from borrowers who default on their loan payments.

What Is an Amortized Bond?

An amortized bond is one in which the principal (face value) on the debt is paid down regularly, along with its interest expense over the life of the bond. A fixed-rate residential mortgage is one common example because the monthly payment remains constant over its life of, say, 30 years. However, each payment represents a slightly different percentage mix of interest versus principal. An amortized bond is different from a balloon or bullet loan, where there is a large portion of the principal that must be repaid only at its maturity.

Understanding Amortized Bonds

The principal paid off over the life of an amortized loan or bond is divvied up according to an amortization schedule, typically through calculating equal payments all along the way. This means that in the early years of a loan, the interest portion of the debt service will be larger than the principal portion. As the loan matures, however, the portion of each payment that goes towards interest will become lesser and the payment to principal will be larger. The calculations for an amortizing loan are similar to that of an annuity using the time value of money, and can be carried out quickly using an amortization calculator.

Amortization of debt affects two fundamental risks of bond investing. First, it greatly reduces the credit risk of the loan or bond because the principal of the loan is repaid over time, rather than all at once upon maturity, when the risk of default is the greatest. Second, amortization reduces the duration of the bond, lowering the debt’s sensitivity to interest rate risk, as compared with other non-amortized debt with the same maturity and coupon rate. This is because as time passes, there are smaller interest payments, so the weighted-average maturity (WAM) of the cash flows associated with the bond is lower.

Example of Amortizing a Bond

30-year fixed-rate mortgages are amortized so that each monthly payment goes towards interest and principal. Say you purchase a home with a $400,000 30-year fixed-rate mortgage with a 5% interest rate. The monthly payment is $2,147.29, or $25,767.48 per year.

At the end of year one, you have made 12 payments, most of the payments have been towards interest, and only $3,406 of the principal is paid off, leaving a loan balance of $396,593. The next year, the monthly payment amount remains the same, but the principal paid grows to $6,075. Now fast forward to year 29 when $24,566 (almost all of the $25,767.48 annual payments) will go towards principal. Free mortgage calculators or amortization calculators are easily found online to help with these calculations quickly.

Straight-Line vs. Effective-Interest Method of Amortization

Treating a bond as an amortized asset is an accounting method used by companies that issue bonds. It allows issuers to treat the bond discount as an asset over the life of the bond until its maturity date. A bond is sold at a discount when a company sells it for less than its face value and sold at a premium when the price received is greater than face value.

If a bond is issued at a discount—that is, offered for sale below its par or face value—the discount must be treated either as an expense or it can be amortized as an asset. In this way, an amortized bond is used specifically for tax purposes because the amortized bond discount is treated as part of a company’s interest expense on its income statement. The interest expense, a non-operating cost, reduces a company’s earnings before tax (EBT) and, therefore, the amount of its tax burden.

Effective-interest and straight-line amortization are the two options for amortizing bond premiums or discounts. The easiest way to account for an amortized bond is to use the straight-line method of amortization. Under this method of accounting, the bond discount that is amortized each year is equal over the life of the bond.

Companies may also issue amortized bonds and use the effective-interest method. Rather than assigning an equal amount of amortization for each period, effective-interest computes different amounts to be applied to interest expense during each period. Under this second type of accounting, the bond discount amortized is based on the difference between the bond’s interest income and its interest payable. Effective-interest method requires a financial calculator or spreadsheet software to derive.

What Is an Allowance for Bad Debt?

An allowance for bad debt is a valuation account used to estimate the amount of a firm’s receivables that may ultimately be uncollectible. It is also known as an allowance for doubtful accounts. When a borrower defaults on a loan, the allowance for bad debt account and the loan receivable balance are both reduced for the book value of the loan.

How an Allowance for Bad Debt Works

Lenders use an allowance for bad debt because the face value of a firm’s total accounts receivable is not the actual balance that is ultimately collected. Ultimately, a portion of the receivables will not be paid. When a customer never pays the principal or interest amount due on a receivable, the business must eventually write it off entirely.

Methods of Estimating an Allowance for Bad Debt

There are two primary ways to calculate the allowance for bad debt. One method is based on sales, while the other is based on accounts receivable.

Sales Method

The sales method estimates the bad debt allowance as a percentage of credit sales as they occur. Suppose that a firm makes $1,000,000 in credit sales but knows from experience that 1.5% never pay. Then, the sales method estimate of the allowance for bad debt would be $15,000.

Accounts Receivable Method

The accounts receivable method is considerably more sophisticated and takes advantage of the aging of receivables to provide better estimates of the allowance for bad debts. The basic idea is that the longer a debt goes unpaid, the more likely it is that the debt will never pay. In this case, perhaps only 1% of initial sales would be added to the allowance for bad debt.

However, 10% of receivables that had not paid after 30 days might be added to the allowance for bad debt. After 90 days, it could rise to 50%. Finally, the debts might be written off after one year.

Requirements for an Allowance for Bad Debt

According to generally accepted accounting principles (GAAP), the main requirement for an allowance for bad debt is that it accurately reflects the firm’s collections history. If $2,100 out of $100,000 in credit sales did not pay last year, then 2.1% is a suitable sales method estimate of the allowance for bad debt this year. This estimation process is easy when the firm has been operating for a few years. New businesses must use industry averages, rules of thumb, or numbers from another business.

Default Considerations

When a lender confirms that a specific loan balance is in default, the company reduces the allowance for doubtful accounts balance. It also reduces the loan receivable balance, because the loan default is no longer simply part of a bad debt estimate.

Adjustment Considerations

The allowance for bad debt always reflects the current balance of loans that are expected to default, and the balance is adjusted over time to show that balance. Suppose that a lender estimates $2 million of the loan balance is at risk of default, and the allowance account already has a $1 million balance. Then, the adjusting entry to bad debt expense and the increase to the allowance account is an additional $1 million.