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How to Calculate Bad Debt Reserves
By Michael C. Dennis, MBA, CBF

In conformity with Generally Accepted Accounting Principles, accounts receivable are reported in the financial statements at net realizable value. Net realizable value is equal to the gross amount of receivables less an estimated allowance for uncollectible accounts. A reserve for bad debts is an estimate of uncollectible accounts receivable. It is sometimes called an allowance for bad debts. It is a 'contra' account when it is listed with the current assets because it will have a credit balance instead of a debit balance since it is a reduction of accounts

One of the responsibilities that most credit departments have is writing off accounts to bad debt. Another is determining what the reserve or allowance for bad debt should be - in order to properly account for potential future bad debt losses. A bad debt exists if, at the date of its financial statements, a creditor does not expect to collect the full amount of its accounts receivable. Under this circumstance, an accrual for a loss contingency must be charged to income, if both of the following conditions exist:

(1) It is probable that as of the date of the financial statements an asset has been impaired or a liability incurred, based on subsequent available information prior to the issuance of the financial statements, and

(2) The amount of the loss can be reasonably estimated.
If both of the above conditions are met, an accrual for the estimated allowance amount of uncollectible receivables must be made even if the specific uncollectible receivables cannot be identified. A company may base its estimate of uncollectible receivables on any number of techniques including:

  • Its prior experience,

  • An evaluation of each debtor's ability to pay,

  • An appraisal of the loss history of the industry in which the creditor company operates

  • A percentage of the open accounts receivable balance

  • A percentage of the balance over 90 days past due

Two common procedures of accounting for bad debts are:

  • The direct write-off method, and

  • The allowance method.

The direct write off method.

The direct write-off method is not acceptable for the purposes of GAAP. The weaknesses of the direct write-off method are:

  • Bad debt expense is not matched with the related sales.

  • Accounts receivable are overstated because no attempt is made to account for the unknown bad debts included in the A/R.

The allowance method

Under the allowance method, a percentage of each period's sales/revenue or ending accounts receivable is estimated to eventually prove uncollectible. Consequently, the amount estimated is charged to bad debts of the period and the credit is made to an account such as allowance for doubtful accounts. When specific accounts are written off, they are charged to the allowance account, which is periodically recomputed. Thus, the expenses are estimated and recorded to match revenues and expenses in a given period - satisfying the matching principle.

I recommend a three-pronged approach to establishing a bad debt reserve:

  • A general reserve based on a percent of prior year sales. Example 2/10 of 1% of prior year sales

  • A specific reserve for accounts already identified as problematic - including accounts in bankruptcy or placed for collection

  • A high-risk reserve - based on accounts identified by the credit department as problems - including customers that are slow pay, and/or highly leveraged and/or disputing the outstanding balance.

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