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Sometimes known as a loan-loss reserve, a bad debt provision is an account that is equal to the portion of current accounts receivable that may ultimately remain uncollected from customers. Banks also make use of this type of provision, effectively protecting themselves from the possibility of losses that would otherwise impair the ability of the financial institution to continue providing services to customers. In both scenarios, the idea of allowing a bad debt provision is to minimize the chances for an interruption in operations due to receivables that are unpaid and likely to be irrecoverable.
In practice, the balance found in a bad debt provision account helps to cover losses that are incurred when a business or financial institution must write off a portion of the receivables as bad debt. Banks may choose to utilize the resources in this account when customers choose to abandon checking accounts with negative balances. While writing off the negative balance as a loss, the loss is covered by funds contained in the allowance for bad debt account, a move that helps to prevent the loss from impairing the bank’s ability to continue providing services to other customers.
Banks also factor in a bad debt provision when it comes to loans. The amount of the provision depends on the total amount of loans that are active at any given point in time. By identifying the total face value of those loans, it is possible to utilize a formula to determine how much should be maintained in the bad debt provision, a move that allows the bank to remain solvent as long as that calculation of losses is not exceeded and the balance in the loan-loss reserve depleted completely. The exact formula used will vary, based on a number of factors including historical data related to losses incurred in past years of operation.
A bad debt provision works much in the same way with other types of businesses. For example, if a company extends credit to a customer and that client eventually defaults on the balance of that credit account, the amount will be considered noncollectable once all reasonable means of collection have failed. At that point, the balance is considered a loss, with that loss covered by the balance in the valuation account set aside to cover bad debts. In order to balance the accounting records, the funds are transferred out of the bad debt account and into receivables, making it possible to retire the invoices associated with the abandoned and noncollectable credit account.
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