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. Also known as an allowance for doubtful accounts, it comes into play when a borrower defaults on a loan. Both the allowance for bad debt account and the loan receivable balance are reduced for the book value of the loan.
Key Takeaways
- An allowance for bad debt is a valuation account used to estimate uncollectible receivables.
- The face value of a firm’s total accounts receivable is not the actual balance that will be collected.
- The primary methods for estimating the allowance for bad debt are the sales method and the accounts receivable method.
- It must accurately reflect the firm’s collections history, according to generally accepted accounting principles (GAAP).
The Mechanics of Allowance for Bad Debt
Lenders rely on an allowance for bad debt because the face value of a firm’s total accounts receivable isn’t the actual balance that will be collected. Some portion of the receivables will inevitably not be paid. When a customer fails to pay the principal or interest on a receivable, the business must eventually write it off entirely.
Methods of Estimating an Allowance for Bad Debt
Sales Method
The sales method estimates the bad debt allowance as a percentage of credit sales as they occur. For instance, if a firm makes $1,000,000 in credit sales and expects 1.5% will be bad debts based on past experience, the sales method estimate for the allowance for bad debt would be $15,000.
Accounts Receivable Method
The accounts receivable method uses the aging of receivables to provide better estimates. The longer a debt goes unpaid, the more likely it is to remain unpaid. For example, possibly only 1% of initial sales would be added to the allowance for bad debt, while 10% of receivables unpaid after 30 days might be added. This could rise to 50% after 90 days, with the debts eventually written off after one year.
Key Conditions for an Allowance for Bad Debt
According to GAAP, the key requirement for an allowance for bad debt is an accurate reflection of the firm’s collections history. For example, if $2,100 out of $100,000 in credit sales went unpaid last year, 2.1% would be a suitable sales method estimate for the allowance for bad debt this year. New businesses can use industry averages, rules of thumb, or data from another business until they’ve developed their collection history.
An accurate estimate of the allowance for bad debt is essential to determine the actual value of accounts receivable.
Addressing Defaults
When a lender confirms that a specific loan balance is in default, the company reduces both the allowance for doubtful accounts balance and the loan receivable balance.
Adjusting for Current Balances
The allowance for bad debt reflects the current balance of loans that are expected to default, and is adjusted over time. For instance, if a lender estimates $2 million of the loan balance is at risk of default, and the allowance account already has $1 million, the adjusting entry to bad debt expense would be an additional $1 million.
Related Terms: accounts receivable, default, bad debt, GAAP, book value.
