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What is an Allowance for Bad Debt?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 18 November 2016
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Also known as an allowance for doubtful accounts, an allowance for bad debt is an accounting provision that makes it possible for a business to absorb some amount of revenue that remains uncollected from invoices sent to customers, or from past due loans issued by the business. The idea of making this type of allowance is to create a small cushion that helps to minimize the effect of the uncollected debt on the financial well-being of the company. Both small and large businesses make this allowance as part of the ongoing accounting process.

In many cases, the business will determine the amount of the allowance for bad debt based on the average amount of accounts receivable that is carried each month. For example, if a company usually has an average receivables each month of $500,000 in US Dollars (USD), the allowance may be set at around 5%, or $25,000 USD. Other factors may also be taken into consideration, such as the average aging of customer invoices. If a number of larger customers customarily pay invoices between sixty and ninety days, rather than in the thirty to forty-five day range, this may affect the percentage used to calculate the allowance.

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Whatever the amount of the allowance for bad debt, the figure is still considered part of the receivables, and is accounted for in that portion of the accounting records. However, the business will attempt to always keep that same amount on hand in the operating account. If the worst case scenario comes to pass, and the total sum of the allowance is not collected in a given month, the ability of the company to honor its own debt obligations remains relatively unaffected. This means that the allowance provides a similar function to a contingency or emergency fund that is set aside as part of a household budget.

Operating with an allowance for bad debt is especially important for small businesses. Since it is not unusual for businesses of this type to operate on a shoestring budget, failing to build some sort of cushion into the accounting process could have dire consequences if several invoices to customers remain uncollected and eventually have to be written off as uncollectable. By positioning the business so that it can still pay its operating expenses on time, even if a certain portion of the receivables is deemed uncollectable, the company protects its credit rating and its relationships with various vendors and suppliers.

Periodic evaluation of the current allowance for bad debt is necessary. This can be performed by analyzing data like the average monthly amount of the receivables, the rate at loan payments are received, and how quickly customers are remitting payments on outstanding invoices. When those factors change, the figure for the allowance could also change, depending on the extent of the shift.

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Logicfest
Post 3

@Terrificli -- because assuming less risk would mean it would be more difficult for consumers to get credit cards and they would spend less money. Whether that theory is right or wrong may be a discussion for another time.

Still, you will find no shortage of economists who say that assuming a certain amount of risk is good for the economy as a whole. Credit has allowed for the expansion of the United States economy and there are a lot of people who say the benefits of that expansion -- jobs, money, etc. -- is well worth the risk.

Terrificli
Post 2

@Vinzenzo -- that risk assumption has been highly criticized by consumer groups through the years. If a credit card company knows a significant percentage of accounts will go into default, then why take on that much risk? Why penalize good, paying customers with high interest rates because some loans will go bad?

Vincenzo
Post 1

It seems some companies have gone far past building in an allowance for bad debt. Credit card companies, for example, consider bad debt when setting interest rates. One of the reasons interest rates are so high on credit cards is that the companies that issue them know a good number of accounts will go into default through bankruptcy and other eventualities.

Such is the cost of doing business, and credit card companies jack up their interest rates because they know some loans will not be collected.

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