What is Bad Debt Reserve (Allowance)?
A bad debt reserve, also known as the allowance for doubtful accounts, is the amount of provision made by the company against the accounts receivable present in the books of accounts of the company for which it is more likely that the company will not be able to collect the money in future.
It is an account that offsets (reduces) the accounts receivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. in the books of accounts.
The thumb rule of business is generating profit. Keeping non-profit organizations aside, which work for the betterment of society, all other organizations work towards earning a profit utilizing 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, which we refer to as a credit periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy..
E.g., Great & Co. is involved in manufacturing heavy machinery, which generally costs more than $ 1,00,000 per piece. In this case, the payment terms defined as per the company policy are as follows:
- The advance of 10% on acceptance of an 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 Small & Co., which is involved in the business of supplying leather accessories such as wallets, belts, etc. Unlike Great & Co., Small & Co. has straightforward payment terms. The company’s credit policy is that all payments are due within 45 days of delivery of goods to the customer.
No matter how simple or complex the credit policy or payment terms a company has, there is 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.
Table of contents
- What is Bad Debt Reserve (Allowance)?
- Why is a bad debt reserve required?
- Bad Debt Reserve Example
- Bad Debt Reserve Accounting
- Techniques to estimate the bad debt allowance
- Provision Percentage for Bad Debt Expense
- How is bad debt reserve used to manipulate the books of accounts?
- Bad Debt Reserve Video
- Recommended Articles
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 principleAccounting PrincipleAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts. is the Conservatism Principle of Accounting, indicating that losses should be accounted for at the earliest. In contrast, profit should be accounted for only after sufficient proof is available that the profit will be accrued shortly.
Since there is always a possibility of debts turning bad and customers not paying the entire amount, we tend to maintain a reserve in the books of accounts for future events.
Bad Debt Reserve in Video
Bad Debt Reserve Example
To understand how it works, let us first see the basic entry we pass for accounting for 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 per the pre-approved terms of tradeTerms Of TradeTerms of Trade (TOT) is defined as the ratio of a country's import and export prices. The concept of terms of trade is important in economics as it explains the extent to which a nation can fund its imports based on the returns of its exports.. The inventory risk has been passed on to the customer when the customer has accepted the delivery of goods. At this point, 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, Accounts Receivable will always show a debit balanceDebit BalanceIn a General Ledger, when the total credit entries are less than the total number of debit entries, it refers to a debit balance. A debit balance is a net amount often calculated as debit minus credit in the General Ledger after recording every transaction. in the books, whereas sales revenue will be transferred to the 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 the net Accounts Receivable to be presented in the Books of Accounts will be $ 4950 (Balance Sheet of the company)Balance Sheet Of The Company)A balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets 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 reserve journal entry. It is because there are two ways to account for a Bad Debt Expense:
- The direct bad debt writes off method – This particular method is used when the organization can pinpoint the invoice for which payment will not 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. It is an aggressive method; in this case, the entire invoice is reversed, which also leads to the reversal of taxes and other statutory dues booked along with the invoice.
- The provisioning 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 periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance., 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 and accrual accountingAccrual AccountingAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. concept.
Matching concept revenue booked in a given period should match the expenses incurred towards earning the revenue. It means expenses should also be recognized in the same period revenue is recognized. Using the provision method, you can recognize a bad debtBad DebtBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation. allowance in the period in which the revenue is booked.
The advantage of the provision method is the disadvantage of the direct bad debt writeWriteWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.off method. It does not go well with the matching accounting concept and is therefore not accepted by the Accounting Standards. When the revenue is booked, there will always be a time lag, and the company is sure that the amount will not be receivable.
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 of expense to be booked on account of bad debt allowance. Several techniques are available for estimating the bad debt allowance; however, some of the most important ones are as follows:
#1 – Historical Data
Historical data provides a good base for predictions and estimations. Trend analysisTrend AnalysisTrend analysis is an analysis of the company's trend by comparing its financial statements to analyze the market trend or analysis of the future based on past performance results, and it is an attempt to make the best decisions based on the results of the analysis done. can be performed on historical data, which can be used to estimate the required bad debt expenseEstimate The Required Bad Debt ExpenseBad debt expense is an expense recorded in financial statements when the amount receivable from debtors is unrecoverable owing to the debtors' inability to meet their financial obligations and can be calculated using the direct method of allowance/estimation method..
The following historical data gives an overview of debt turning bad in a given period as a percentage of the total receivables booked.
|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 company’s actual bad debt is increasing yearly 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 less than 2%, and 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 company’s decision-makers. But there can be cases where no trend can be developed, no past data is available, or the data available is not complete/correct. The company can opt for other techniques to estimate the bad debt allowance in these cases.
#2 – Pareto analysis
Pareto analysisPareto AnalysisPareto analysis is a decision making technique based on the 80/20 rule where the company can achieve 80% of the project's benefits by doing the 20% of the work, or the 80% problems of the company are traced to 20 % causes. is a statistical technique that can estimate the amount of bad debt allowance. The pareto principle is governed by the 80-20 rule80-20 RuleThe 80-20 rule or Pareto Principle is a phenomenon primarily used in business and economics that explains how 20% of efforts or inputs can yield 80% of results or outputs. It helps identify and focus on the crucial factors to create maximum value while delegating the least important ones., which means that 80% of the benefit is derived from doing just 20% of the work.
Applying this principle to accounts receivable, we can say that 80% of the total accounts receivable presented in the books of accounts comprises 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 expenses, the company can focus on the remaining 80% of the customers, which will account for only 20% of the accounts receivable on the balance sheet.
There is no perfect method, and a company can opt for it, 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 that a company can incur generally depends on the following factors:
#1 – Credit policy of the company:
The company’s credit policy is governed by the company’s risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation. as a whole. If the company is a risk-taker, 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 policies are prone to lesser bad debt expenses than companies that 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 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 also depends on the sector to which the company belongs. e.g., the telecommunication sector has its major source of revenue through its prepaid customers. In this sector, companies have to account for bad debt allowance only for their post-paid customers. There is no scope for bad debt expenses as it provides services only after receipt of money.
#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 brackets, figure out the reasons for the delay, and 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 through constant follow-up.
How is a bad debt reserve used to manipulate the books of accounts?
- It is a good technique that can be used to decrease the net taxable profit of the company, which will help reduce income tax expenses. Therefore, strict tax rules will prevent companies from taking advantage of the bad debt reserve for tax-saving purposes.
- Actual bad debt expenses can lead to huge losses. To show a better financial position, managers may use window dressingWindow DressingWindow dressing in accounting refers to the intentional manipulation of financial statements by company management in order to present a more favourable picture of the company to users of the financial statement before it is released to the public. techniques to reduce the total bad debt expense and show accounts receivable. It will not only increase the current assetsThe Current AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. of the company but also reduce actual losses incurred.
To avoid the above situations, the top-down approach to management and strict policies will go a long way in securing the company’s future.
This article has been a guide to what is Bad Debt Reserve and its definition. Here we discuss accounting for bad debt allowance along with examples and provisions for Bad Debt Expenses. You can also go through the following accounting articles to learn more –