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An accounts receivable reserve is a type of reserve account that is created to offset losses that are incurred when clients fail to remit payments on outstanding invoices. The idea of the reserve is to prevent the company from experiencing severe financial hardship due to the non-payment. A reserve account of this type can be used to offset the impact of invoices that remain due when a client declares bankruptcy, goes out of business, or simply does not pay, and the balance is turned over to a collection agency.
There are a number of strategies that can be used to determine the amount of funds that are allocated to an accounts receivable reserve. One of the more common approaches is to make use of historical data that involves the both the percentage and the actual amounts of invoice defaults that occurred within a given time frame. A slightly different approach calls for basing the amount on the aging of invoices, with the balance in the reserve based on the sum total of invoices that are over 90 days old. Choosing the best approach often depends on the circumstances of the business proper, and how easily the company could recover if older invoices are ultimately not paid in full.
The main benefit of establishing and maintaining an accounts receivable reserve is that the company is somewhat insulated from the ill effects generated by a failure of clients to remit payments for outstanding invoices. By having reserves on hand, the business is able to offset those losses and continue to disburse payments to vendors and suppliers without fail. As a result of having a sufficient amount of funds in the reserve, it is possible to avoid incurring late fees and other penalties on the payables that would only increase the debt obligations of the company, making it even harder to remain financially stable.
Guidelines regarding when to make use of the funds in an accounts receivable reserve will vary. Some companies require that delinquent customer accounts must be submitted for collections before funds from the reserve can be used to offset the losses. Other firms employ a practice of withdrawing funds from the accounts receivable reserve when invoices reach a certain level of aging, such as 120 days after issue. In the event that funds are received due to collection efforts or that the client submits a payment after the account has reached the aging threshold, those payments can be used to replenish the reserve, allowing the business to maintain this type of nest egg for the future.