Calculating Bad Debt Reserves

U.S. Generally Accepted Accounting Principles requires companies to use the allowance method for recording uncollectible accounts receivable. Under the allowance method, entities estimate the amount of expected uncollectible accounts. The estimate is recorded as an expense and reduces accounts receivable through an allowance account.  As a result, accounts receivable are reported in the financial statements at net realizable value.

Net realizable value means the gross amount of receivables less an estimated allowance for bad debts.  An allowance for bad debts is an estimate of uncollectible accounts receivable.  On the Balance Sheet, this allowance is a "contra" account since it reduces accounts receivable.  

One of the responsibilities of most credit departments involves writing off customer accounts receivable to bad debt. A related responsibility involves determining what the reserve or allowance for bad debt should be.  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 potential loss must be recorded provided that both of the following conditions exist:

• 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
• 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 but not limited to:

• 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 permitted under Generally Accepted Accounting Principles because:

• Bad debt expense is not matched with the related sales in violation of the Matching Principle,
• Accounts receivable are overstated because no attempt is made to account for the unknown bad debts included in the A/R in violation of the Conservatism Principle.

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 for 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  in a given period - satisfying the matching principle.

© 2011 by Michael C. Dennis.  All Rights Reserved.  Michael is the author of "Credit and Collection Handbook."