What Is an Allowance for Bad Debt?
Let me explain what an allowance for bad debt is—it's a valuation account you use to estimate how much of your firm's receivables might end up uncollectible. You might also hear it called an allowance for doubtful accounts. When a borrower defaults on a loan, you reduce both this allowance account and the loan receivable balance by the book value of that loan.
How an Allowance for Bad Debt Works
You need an allowance for bad debt because the face value of your total accounts receivable isn't the amount you'll actually collect. Some portion of those receivables won't get paid. When a customer fails to pay the principal or interest on a receivable, you have to write it off completely at some point.
Methods of Estimating an Allowance for Bad Debt
There are two main ways to calculate this allowance. One bases it on sales, and the other on accounts receivable.
Sales Method
With the sales method, you estimate the bad debt allowance as a percentage of your credit sales right when they happen. For example, if your firm has $1,000,000 in credit sales and experience shows 1.5% never pay, your estimate for the allowance would be $15,000.
Accounts Receivable Method
The accounts receivable method is more advanced—it uses the aging of receivables to get better estimates. The idea is simple: the longer a debt remains unpaid, the less likely you'll collect it. You might add just 1% of initial sales to the allowance, but for receivables unpaid after 30 days, it could be 10%. After 90 days, maybe 50%, and after a year, you might write them off entirely.
Requirements for an Allowance for Bad Debt
Under generally accepted accounting principles (GAAP), the key requirement is that your allowance accurately reflects your firm's collections history. If last year $2,100 out of $100,000 in credit sales went unpaid, then 2.1% is a good estimate for this year's sales method. This is straightforward if your business has been around a while; new firms should use industry averages, rules of thumb, or data from similar businesses. Remember, an accurate estimate is essential to determine the real value of your accounts receivable.
Default Considerations
When you confirm a specific loan is in default, you reduce the allowance for doubtful accounts balance and the loan receivable balance. At that point, it's no longer just an estimate—it's a confirmed bad debt.
Adjustment Considerations
Your allowance for bad debt should always show the current balance of loans expected to default, so you adjust it over time. If you estimate $2 million of your loan balance is at risk and your allowance already has $1 million, you make an adjusting entry to bad debt expense and increase the allowance by another $1 million.
Other articles for you
Form 1099-DIV is an IRS form used by financial institutions to report dividends and distributions to investors for tax purposes.
The 52-week high/low represents a stock's peak and trough prices over a year, serving as vital indicators for trading decisions and potential price movements.
The LIBOR scandal involved banks manipulating a key interest rate, leading to fines, lawsuits, and its eventual replacement.
Rent control is a government program that limits landlord rent charges to keep housing affordable, though it's controversial and limited in the US.
A term sheet is a nonbinding document outlining basic terms for investments, deals, or loans to facilitate negotiations before a formal contract.
An emerging industry involves companies forming around new products or ideas in early development, often tied to innovative technologies with high risks and potential rewards.
The Lintner model is an economic formula that helps determine optimal corporate dividend policies by focusing on target payout ratios and adjustment speeds.
An appropriation account details how profits or funds are allocated for specific purposes in businesses and governments.
The eclectic paradigm is a framework for evaluating foreign direct investments through ownership, location, and internalization advantages.
Love money is seed capital provided by family or friends to help entrepreneurs start or fund businesses when traditional financing isn't available.