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. It is also known as an allowance for doubtful accounts. When a borrower defaults on a loan, the allowance for bad debt account and the loan receivable balance are both reduced for the book value of the loan.
Key Takeaways
- An allowance for bad debt is a valuation account used to estimate the amount of a firm’s receivables that may ultimately be uncollectible.
- Lenders use an allowance for bad debt because the face value of a firm’s total accounts receivable is not the actual balance that is ultimately collected.
- The primary ways of estimating the allowance for bad debt are the sales method and the accounts receivable method.
- According to generally accepted accounting principles (GAAP), the main requirement for an allowance for bad debt is that it accurately reflects the firm’s collections history.
How an Allowance for Bad Debt Works
Lenders use an allowance for bad debt because the face value of a firm’s total accounts receivable is not the actual balance that is ultimately collected. Ultimately, a portion of the receivables will not be paid. When a customer never pays the principal or interest amount due on a receivable, the business must eventually write it off entirely.
Methods of Estimating an Allowance for Bad Debt
There are two primary ways to calculate the allowance for bad debt. One method is based on sales, while the other is based on accounts receivable.
Sales Method
The sales method estimates the bad debt allowance as a percentage of credit sales as they occur. Suppose that a firm makes $1,000,000 in credit sales but knows from experience that 1.5% never pay. Then, the sales method estimate of the allowance for bad debt would be $15,000.
Accounts Receivable Method
The accounts receivable method is considerably more sophisticated and takes advantage of the aging of receivables to provide better estimates of the allowance for bad debts. The basic idea is that the longer a debt goes unpaid, the more likely it is that the debt will never pay. In this case, perhaps only 1% of initial sales would be added to the allowance for bad debt.
However, 10% of receivables that had not paid after 30 days might be added to the allowance for bad debt. After 90 days, it could rise to 50%. Finally, the debts might be written off after one year.
Requirements for an Allowance for Bad Debt
According to generally accepted accounting principles (GAAP), the main requirement for an allowance for bad debt is that it accurately reflects the firm’s collections history. If $2,100 out of $100,000 in credit sales did not pay last year, then 2.1% is a suitable sales method estimate of the allowance for bad debt this year. This estimation process is easy when the firm has been operating for a few years. New businesses must use industry averages, rules of thumbor numbers from another business.
An accurate estimate of the allowance for bad debt is necessary to determine the actual value of accounts receivable.
Default Considerations
When a lender confirms that a specific loan balance is in default, the company reduces the allowance for doubtful accounts balance. It also reduces the loan receivable balance, because the loan default is no longer simply part of a bad debt estimate.
Adjustment Considerations
The allowance for bad debt always reflects the current balance of loans that are expected to default, and the balance is adjusted over time to show that balance. Suppose that a lender estimates $2 million of the loan balance is at risk of default, and the allowance account already has a $1 million balance. Then, the adjusting entry to bad debt expense and the increase to the allowance account is an additional $1 million.