Bad Debt Reserve

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 receivables 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 period.

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:

1. The advance of 10% on acceptance of an order.
2. Release of 30% payment on completion of 50% of the work order after certification by the customer
3. Release of 30% payment on delivery of the machinery at the customer’s warehouse
4. 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.

Accounting has its own rules and principles which need to be adhered to while maintaining and updating books of accounts. The basic governing accounting principle 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.

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 trade. 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:

As we can see, Accounts Receivable will always show a debit balance 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:

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).

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:

1. 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.
2. 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 period, 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 accounting 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 debt allowance in the period in which the revenue is booked.

The advantage of the provision method is the disadvantage of the direct bad debt write 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.

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 analysis can be performed on historical data, which can be used to estimate the required bad debt expense.

The following historical data gives an overview of debt turning bad in a given period as a percentage of the total receivables booked.

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 analysis is a statistical technique that can estimate the amount of bad debt allowance. The pareto principle is governed by the 80-20 rule, 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.

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 appetite 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.

• 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 dressing techniques to reduce the total bad debt expense and show accounts receivable. It will not only increase the current assets 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 –

• Bad Debt Provision Examples
• Bank Reserve
• Debt Relief Examples
• Reserve Price