Establishing an Appropriate Bad Debt Reserve
By Dorothy Siegel

A bad debt is a term used to describe an accounts receivable balance that has become totally or partially uncollectable. Since most credit managers have no choice but to release orders to accounts they have classified as marginal credit risks, bad debt losses are inevitable. Under Generally Accepted Accounting Principles, accounts receivable must be 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 uncollectable accounts. A creditor company does not expect to collect the full amount of its accounts receivable. A company may base its estimate of uncollectable receivables on its prior experience, the experience of other companies in the same line of business, on individual debtors' ability to pay, and an appraisal of current economic conditions affecting the creditor company's business.

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

• 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 worrisome - including customers that are slow pay, and/or highly leveraged and/or disputing the outstanding balance.

Reprinted with permission from the Covering Credit Newsletter 9/19/02 Edition © 2001 All Rights Reserved.