What is Bad Debt Reserve (Allowance)?
Bad debt reserve is an account which offsets (reduces) the accounts receivables in the books of accounts.
The thumb rule of business is generating profit. Keeping non-profit organizations aside, which work for the betterment of the society, all other organizations work towards earning a profit by means of increasing revenue. As we all know, revenue earned by organizations is not settled by cash at the time of delivery of goods or completion of service. There is a time lag in between which we refer to as credit period.
E.g. Great & Co. is involved in the business of manufacturing heavy machinery which generally cost more than $ 1,00,000 per piece. In this case, the payment terms defined as per the company policy are as follows:
- Advance of 10% on acceptance of order
- Release of 30% payment on completion of 50% of the work order after certification by the customer
- Release of 30% payment on delivery of the machinery at the customer’s warehouse
- Release of full and final payment 30 days after the delivery
As you must have noticed, the payment terms in the above case are a bit complex. Now let us take another example of letting us take an example of Small & Co. which is involved in the business of supplying leather accessories such as wallets, belts, etc. The credit policy of the company is that all payments are due within 45 days of delivery of goods to the customer. As opposed to Great & Co., Small & Co. has very simple payment terms.
No matter how simple or complex the credit policy or payment terms a company has, they are bound to be some credit risk involved. Credit risk is nothing but the fact that the customer might not end up paying the money when due. There are no two thoughts about the fact that this would lead to loss to the company. To account for this loss, the company maintains a provision in its books of accounts which are known as the Bad Debt Reserve.
Why is a bad debt reserve required?
Accounting has its own rules and principles which need to be adhered to while maintaining and updating books of accounts. The basic governing accounting principle is Conservatism – which indicates that losses should be accounted for at the earliest while profit should be accounted for only after sufficient proof is available that the profit will be accrued in the near future.
Since there is always a possibility of debts turning bad and customers not paying the complete amount, we tend to maintain a reserve in the books of accounts for future events called as bad debt reserve.
Bad Debt Reserve Example
To understand how bad debt reserve works, let us first see the basic entry which we pass for accounting a credit sale transaction in the books of accounts.
Small & Co. has received an order of 500 leather wallets at the selling price of $ 10 each. It has successfully delivered these goods at the customer’s warehouse as per the pre-approved terms of trade. The risk of the inventory has been passed on the customer when the customer has accepted delivery of goods. At this point of time, we pass the following journal entry in the books:
|Accounts Receivable A/c …. Debit||$ 5000|
|To Sales A/c ….. Credit||$ 5000|
As we can see, that Accounts Receivable will always show a debit balance in the books whereas sales being revenue will be transferred to profit & loss account.
Now, as the purpose of the bad debt reserve is to offset the Accounts Receivables, it will have a credit balance in the books of accounts. The journal entry for bad debt reserve is as follows:
|Bad Debt Expense A/c or Allowance for Bad debt A/c …. Debit||$ 50|
|To Bad Debt Reserve A/c ….. Credit||$ 50|
The Bad Debt Reserve account will reduce the Accounts Receivable A/c by $ 50 and net Accounts Receivable to be presented in the Books of Accounts will be $ 4950 (Balance Sheet of the company).
Bad Debt Reserve Accounting
As you must have noticed, two different accounts have been used to give the debit effect for the above bad debt reserver journal entry. This is because there are two ways to account for a Bad Debt Expense:
- The direct bad debt write off method – This particular method is used when the organization can pinpoint invoice for which payment is not going to be received. This method involves writing off the revenue itself and is possible when there is a one to one correlation between the sales and the debt turning bad. This is an aggressive method and in this case, the entire invoice is reversed which also leads to reversal of taxes and other statutory dues booked along with the invoice.
- The provision method – This is a less aggressive method to account for bad debt reserve. In this case, a provision is created for the bad debt expense which can be written off in the next accounting period and again a fresh provision is created. Most organizations prefer to go ahead with this method. This method goes hand in hand with the matching concept and the accrual concept of accounting.
Matching concept revenue booked in a given period should be matched with the expenses incurred towards earning the revenue. Which basically means expenses should also be recognized in the same period in which revenue is recognized. By using the provision method, you can recognise bad debt allowance in the period in which the revenue is booked.
The above advantage of the provision method is the disadvantage of the direct bad debt write off method. There will always be a time lag when the revenue is booked and the company is sure that the amount will not be receivable. This does not go well with the matching concept of accounting and is therefore not accepted by the Accounting Standards as well.
Techniques to estimate the bad debt allowance
After having understood the meaning of bad debt reserve, the next important question is how to determine the amount the amount of expense to be booked on account of bad debt allowance. There are several techniques which are available for estimating the bad debt allowance, however, some of the most important ones are as follows:
#1 – Historical Data
Historical data provides sufficient base for predictions and estimations. Trend analysis can be performed on historical data which can be used to estimate the required bad debt expense.
The following historical data gives an overview of debt turning bad in a given period as a percentage of the total receivables booked in that period.
|Accounts Receivable as on 31-Dec of the given year||$ 1,92,000||$ 2,20,000||$ 1,85,000||$ 2,07,000|
|Actual bad debt expense in the given year||$ 3,500||$ 4,100||$ 3,600||$ 4,050|
|Percentage of actual bad debt expense as a ratio of accounts receivable||1.82%||1.86%||1.95%||1.96%|
From the above data, a trend can easily be determined. It is clear that the actual bad debt of the company is increasing year on year but very steadily. There is not a great jump in any of the given years. The trend has been set in the past years. It is more than evident that the actual bad debt expense for the company is somewhere less than 2%, the company can prudently take 2% of the accounts receivable as bad debt allowance in the calendar year 2017.
Trend analysis and historical data generally give some insight to the decision makers of the company. But there can be cases where no trend no can be developed or no past data is available or the data available is not complete/correct. In these cases, the company can opt for other techniques to estimate the bad debt allowance.
#2 – Pareto analysis
Pareto analysis is a statistical technique which can be used to estimate the amount of bad debt allowance. Pareto principle is governed by the 80-20 rule which means that generally 80% of the benefit is derived by doing just 20% of the work.
Applying this principle to accounts receivable, we can say that generally 80% of the total accounts receivable presented in the books of accounts comprises of 20% of the total number of customers. So, in other words, this 20 % of the customers are recurring and the key customers which will generally not end up defaulting if they want a regular supply of goods or services from the company. For analyzing bad debt expense, the company can focus on the remaining 80% of the customers which will account for only 20% of the accounts receivable of the balance sheet.
There is no perfect method and a company can opt for the method keeping in mind its history, competitiveness in the market, industry experience, etc. A combination of the above methods can also be used.
Provision Percentage for Bad Debt Expense
The amount of bad debt expense which a company can incur generally depends on the following factors:
#1 – Credit policy of the company:
Credit policy of the company is governed by the risk appetite of the company as a whole. If the company is a risk taker then it is bound to have a liberal credit policy e.g. having favorable payment terms such as 60 days credit instead of the usual 45 days credit. On the other hand, a risk-averse company will have a strict credit policy e.g. it may require a thorough background check of all its customers before accepting a new order from them.
Generally speaking, companies with strict credit policy are prone to lesser bad debt expense than companies which have a policy of increasing revenue irrespective of the fact to whom they sell the products.
#2 – Market dynamics:
The economic health of the company, sector, and country is also a determining factor towards the total amount of bad debt expense for a given company. If an economy as a whole is facing difficult times (war, economic depression), bad debt expenses are bound to increase in the country in which goods are supplied.
#3 – Sector to which the company belongs:
The bad debt expense is also dependent on the sector to which the company belongs. e.g. the telecommunication sector has its major source of revenue through its prepaid customers where there is no scope of bad debt expenses as it provides services only after receipt of money. In this sector, companies have to account for bad debt allowance only for its post-paid customers.
#4 – Overall analysis of the company’s accounts receivables by putting them into the following buckets:
- Less than 90 days old
- 91 days to 180 days old
- 181 days to 1 year old
- More than a year old but less than 2 years old
- More than two years old
The company can drill down further into each bucket especially in more than 180 olds bracket and figure out the reasons of delay, settle disputes if any. This exercise will give a fair idea to the company about the debt structure and total provision it should maintain to cover the foreseeable bad debt expenses. On the bright side, this activity might also help recover some long pending debts by constant follow-up.
How is bad debt reserve used to manipulate the books of accounts?
- Bad debt reserve is a good technique which can be used to decrease the net taxable profit of the company which will help reduce tax expense. Therefore, there are strict tax rules which will prevent companies to take benefit of the bad debt reserve for tax saving purposes.
- Actual bad debt expense can lead to huge losses. To show a better financial position, managers may opt for window dressing techniques which will reduce the total bad debt expense and simply show accounts receivable. This will not only increase the current assets of the company but also reduce actual losses incurred.
To avoid the above situations, top-down approach to the management and strict policies will go a long way in securing the future of the company.
This has been a guide to what is Bad Debt Reserve and examples. Here we discuss why is a bad debt reserve required, accounting for bad debt reserve,
techniques to estimate the bad debt allowance and provisions for Bad Debt Expense. You can also go through the following accounting articles to learn more –
- Allowance for Doubtful Accounts
- Days Payable Outstanding
- Types of Credit Facilities
- Average Collection Period Formula