Bad Debt ReserveDefined with Examples & More

Written By:
Lisa Borga

A bad debt reserve, more often known as an allowance for doubtful accounts, is an estimation of the value of receivables that a company does not expect to receive.

This is a contra-asset account that offsets accounts receivable to provide an estimate of the true value of a company’s receivables by accounting for debts that are not expected to be paid.

This may also be known as a doubtful debts provision or a bad debt provision.

Understanding an Allowance for Doubtful Accounts

An allowance for doubtful accounts is a means to account for the value of bad debts a company expects to incur.

This is why it is also known as a bad debt reserve.

This is a contra asset account, which means that it is used to offset the value of another account, in this case, accounts receivable.

This is required under the matching principle of accounting for companies using accrual accounting.

The matching principle requires that the expenses which are associated with a sale should be recorded at the same time as the revenue it generates.

This prevents a situation in which a company may report high profits due to sales that create bad debt, which is then followed by expenses incurred to bad debts.

The allowance for doubtful accounts has a natural credit balance, and accounts receivable, which it offsets, has a natural debit balance.

This means that the allowance for doubtful accounts will offset some of the value of the receivables account, resulting in a net receivable balance which will be listed on the balance sheet.

However, a company generally will not know precisely which debts are unlikely to be paid.

In order to create an estimate for a given period, a firm will generally look at the percentage of bad debts it has occurred in previous periods and carry this forward to estimate the value of bad debts it is likely to incur in the current period.

This may also be adjusted if a firm has additional knowledge concerning the likelihood that particular debts will be paid.

For example, if a company has a long-run average of 5% of sales made on credit proving to be uncollectible, the company will record 5% of credit sales made in each period to its allowance for doubtful accounts.

However, if the company makes several large sales to a customer with a long track record of payment that would make this estimate inaccurate, it may choose to adjust its estimate to account for these transactions.

The reverse would apply if, instead, the company made these sales to a customer it has reason to believe would not pay.

Once a company has arrived at a value for the debts it does not expect to be paid in a period, it will debit this amount to its bad debts expense account and credit the same amount to its allowance for doubtful accounts.

If the company chooses to write off a specific debt as uncollectible, it would debit the allowance for doubtful accounts and credit its accounts receivable.

Allowance for Doubtful Accounts vs. the Direct Write-Off Method

When a company chooses not to use an allowance for doubtful accounts, it will instead use the direct write-off method.

With the direct write-off method, bad debt is written off only once it is decided that it cannot be collected.

However, the use of this method is typically considered to be a poor accounting practice as it delays the recognition of expenses.

As a result, an auditor may not be willing to certify a company’s financial statements unless it begins using an allowance for doubtful accounts.

How Analysts Use the Allowance for Doubtful Accounts

The majority of firms use an allowance for doubtful accounts as a way to account for the value of debts that customers will not pay.

As a result, some analysts look to a company’s allowance for doubtful accounts as an indication of how it is at managing credit.

If investors and analysts see that a company suddenly increases the balance of its allowance for doubtful accounts, this may raise concerns that the company could suffer difficulties with its future cash flow.

This could result from making a larger number of high-risk sales, which could also implicate additional problems.

Alternatively, a company could choose to pay down its allowance for doubtful accounts, which could make it look as if the company is performing worse.

However, it would improve the appearance of future performance due to a smaller allowance for doubtful accounts.

Example of Allowance for Doubtful Accounts

As an example of how an allowance for doubtful accounts would work in practice, let’s consider the ABC Corporation.

This company started the month with no balance in its allowance for doubtful accounts and ended the month of January with a debit balance of $10,000,000 in its accounts receivable.

Based on a historical performance recorded over several accounting periods, the company has found that 3% of its customers will generally not pay.

This means that ABC Corporation expects they will be unable to collect $300,000 of the balance of accounts receivable.

In order to account for the amount the company does not expect they will be able to convert into cash, they will create the following journal entry:

The allowance for doubtful accounts will now report a credit balance of $300,000 which will offset some of the value of accounts receivable.

The balance sheet will now report $9,700,000, the net realizable value of accounts receivable, which is the value that the company expects it will actually be able to convert into cash.

It will also report the $300,000 bad debts expense on the company’s January income statement as well.

Key Takeaways

• An allowance for doubtful accounts provides an estimate of the value of receivables that a company does not expect to be able to collect.
• An allowance for doubtful accounts makes it possible for a company to create a better estimate of the true value of its receivables.
• An allowance for doubtful accounts enables a firm to more accurately plan its cash flow to prevent shortfalls and raise additional capital whenever it may be necessary.
• Over-estimating the value of doubtful accounts can have an adverse impact by making a firm’s future position look weaker than it is.