Allowance for Bad Debt: Definition and Recording Methods
A valuation account known as an allowance for bad debt determines how much of a company’s receivables may be uncollectible. It is often referred to as a provision for disputed accounts. The loan receivable balance and the allowance for bad debt accounts are decreased for the loan’s book value when a borrower defaults on a loan.
How a Bad Debt Allowance Works
Because the complete amount of a company’s accounts receivable is not always what is eventually collected, lenders utilize an allowance for bad debt. In the end, some of the receivables won’t be paid. The business must eventually write off a receivable entirely if a customer does not pay the principal or interest owed on it.
Methods for Calculating a Bad Debt Allowance
The allowance for bad debt might be determined in one of two ways. Both methods are based on accounts receivable, whereas one is based on sales.
Sales Strategy
The bad debt allowance is calculated using the sales method as a proportion of actual credit sales. Let’s say a business sells $1,000,000 worth of credit but knows from experience that 1.5% never pays. The tolerance for bad debt would therefore be estimated using the sales technique at $15,000.
Method of Receivables
The allowance for bad debts can be more accurately estimated using the accounts receivable technique since it uses the receivables aging. The fundamental tenet is that the longer a debt goes unpaid, the greater the likelihood it will never be repaid. In this situation, the tolerance for bad debt might only be increased by 1% of the initial sales.
However, the allowance for bad debt may be increased by 10% of unpaid receivables after 30 days. Ninety days later, it can increase to 50%. Finally, after a year, the obligations might be canceled.
Conditions for a Bad Debt Allowance
According to generally accepted accounting principles (GAAP), the primary criterion for an allowance for bad debt is that it accurately depicts the firm’s history of collections. This year, 2.1% is an acceptable estimate of the allowance for bad debt based on the sales technique if $2,100 out of $100,000 in credit sales from the previous year did not pay. This estimation method is simple when the company has been in business for a while. New enterprises must use industry norms, adages, or figures from another industry.
Regarding Defaults
The business decreases the provision for doubtful accounts balance when a lender determines that a particular loan balance is in default. Because the loan default is no longer included in a bad debt estimate, it also lowers the loan receivable balance.
Considerations for Adjustment
The balance of loans currently expected to default is always reflected in the allowance for bad debt, and it is updated over time to reflect that balance. Consider a scenario where a lender determines that $2 million of the loan debt is susceptible to default, and the allowance account has a balance of $1 million. Then, an additional $1 million is added to the allowance account, and the bad debt charge is an adjusting item.
Conclusion
- A valuation account known as an allowance for bad debt determines how much of a company’s receivables may be uncollectible.
- Because the complete amount of a company’s accounts receivable is not always what is eventually collected, lenders utilize an allowance for bad debt.
- The sales method and the accounts receivable technique are the two main approaches to assessing the allowance for bad debt.
- According to generally accepted accounting principles (GAAP), the primary criterion for an allowance for bad debt is that it accurately depicts the firm’s history of collections.
