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. 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. 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. 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. The primary ways of estimating the allowance for bad debt are the sales method and the accounts receivable method.
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.
An accurate estimate of the allowance for bad debt is necessary to determine the actual value of accounts receivable.
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.
Related terms:
Accounts Receivable Aging
Accounts receivable aging is a report categorizing a company's accounts receivable according to the length of time an invoice has been outstanding. read more
Accounts Receivable (AR) & Example
Accounts receivable is the balance of money due to a firm for goods or services delivered or used but not yet paid for by customers. read more
Allowance for Doubtful Accounts
An allowance for doubtful accounts is a contra-asset account that reduces the total receivables reported to reflect only the amounts expected to be paid. read more
Bad Debt Expense
Bad debt expense is an expense that a business incurs once the repayment of credit previously extended to a customer is estimated to be uncollectible. read more
Bad Debt
Bad debt is an expense that a business incurs once the repayment of credit previously extended to a customer is estimated to be uncollectible. read more
Bad Debt Reserve
A bad debt reserve is the amount of receivables that a company or financial institution does not expect to actually collect. read more
Book Value : Formula & Calculation
An asset's book value is equal to its carrying value on the balance sheet, and companies calculate it by netting the asset against its accumulated depreciation. read more
Contra Account
A contra account is an account used in a general ledger to reduce the value of a related account. A contra account's natural balance is the opposite of the associated account. read more
Face Value
Face value is the nominal value or dollar value of a security stated by the issuer, also known as "par value" or simply "par." read more
Generally Accepted Accounting Principles (GAAP)
GAAP is a common set of generally accepted accounting principles, standards, and procedures that public companies in the U.S. must follow when they compile their financial statements. read more