ALLOWANCE FOR BAD DEBT - BASIC INFORMATION AND TUTORIALS

What is allowance for bad debt? Allowance for bad debt, defined.

Closely related to accounts receivable, but not always shown separately on the balance sheet, is an account called “Allowance for bad debts” or some similar title.

This is a reserve, an estimated amount the company provides for the possibility that some customer balances will not be paid at all and will have to be written off. Any company that sells on credit has these kinds of issues to deal with—granting credit and managing customer relationships so that collection losses are as small as possible, consistent with good business practice.

Because companies cannot tell at first who will pay and who will not, they often provide a reserve for such losses at the time sales are made, typically calculated as a percentage of all sales made in a given period. Such reserves will then absorb the cost of bad debt losses that may be recognized in future periods.

In order to accomplish that, companies build reserves by creating a write-off to expense. They then charge uncollectible amounts off against the reserve whenever they decide they will not likely collect the full amount due.

At any point in time, the allowance for bad debts is effectively a valuation adjustment account that reduces the total amount of customer accounts receivable on the books to the net amount expected to be collected.

Avoiding a Cash Management Pothole

Every company has to manage its accounts carefully to ensure they get paid in full and there are no bad debt losses.

However, since periodic fluctuations in collection experience are a normal risk of doing business, smart managers who have this responsibility will arrange for credit lines with their banks in the event they cannot collect what is due them in time to meet their obligations to their creditors.

A credit line is simply a promise by the bank to lend a company a certain amount of money to tide it over until its customers pay their bills.

The company borrows however much it needs (within the credit limits) whenever it needs it and repays the bank when it collects from its customers. Interest is charged for only the time the amount borrowed is in the company’s hands.