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