Updated July 14, 2023
Definition of Bad Debt Reserve
Bad debt reserve (also known as provision for doubtful debts) is a provision made by any organization regarding those customers to whom sales have been made on credit. Still, the realization against such credit sales has become doubtful in the future, and the management makes such estimates as per their judgment & discretion.
- Reserve means the accumulation of something for a purpose. Similarly, a bad debt reserve is made by an entity in case the customers default.
- Suppose you sold 1000 bottles at $ 5 each on credit to a customer & that makes $ 5000 receivable. It has been 1 year & the customer has not paid yet. So, the company is doubtful whether it can recover the same or not. So, on the safer side, the company judges that 25% may not be recovered. and provision is made for 5000*25% = $ 1250.
- This provision is shown as a reduction from the balance of trade receivables in the company’s balance sheet. Thus, the net amount of trade receivables are receivables for the company.
- The provision is created at the end of every year as per the management’s judgment. Such provision is charged to the profit & loss account of the period in which such provision is recognized. Further, any bad debt is set off from the accumulated provisions balance.
- Thus, bad debts do not impact the company’s profits until the actual bad debt amount is within the accumulated balance of provision for bad & doubtful debts.
How Does It Work?
- There Is a Standard Process for Recognition of Bad Debt Reserve in Any Company.
- Suppose a company sells its goods in 60 days to its 5 customers. The total sales amount is $ 150 million. The company will record this amount as revenue from operations (in the profit & loss account) and trade receivables (in the balance sheet).
- At the end of the year, the company identified that one of its customers to whom sales made $ 30 million had not paid its bill even after 60 days had crossed. After analysis, the company received information that the said customer has been facing losses for the last 2 years back & now the customer is also running into a cash crunch. The customer is in the process of restructuring its venture.
- So, it is clearly understood that there is uncertainty over debt collection from sales customers. Now, it is the call of management to decide whether they want to make provision for 100% of the sales amount or 50% or any other rational percentage. Say, the management has decided on 30% as the best estimate. So, 30% of $ 30 million will be $ 9 million provisions in the company’s books.
- As a matter of fact, will companies with more than 1000 customers go on analyzing each customer, as we did above? Like seriously? A big NO! The management has experience with the recoverability ratio in the industry. So, that experience is used here. Management can presume that 5% of credit sales are normally unrecoverable. So, management will make provision every year @ 5%. This way, the bad debt reserve will go on increasing & accumulating.
How to Calculate Bad Debt Reserve
Following are a few ways & meanings of calculating bad debts reserves:
1. Based on Experience
- An entity can use its industry experience since the company’s inception. Such historical data can be used & modified to arrive at the appropriate prediction percentage.
- The company can use an average historical bad debts ratio to determine the standard percentage for bad debts reserve.
- The ratio of actual debts to accounts receivables can be used for computing the average rate.
- Few entities also consider taking a weighted average instead of a simple average. Weights are given for the time factor. Weighted average means giving more importance to the latest information.
- What if a company does not have historical data? We have the second method, as explained below.
2. Based on Pareto Analysis
- Pareto Principle means the 80-20 rule. This means 80% of things are captured in 20% of work. Say you want to bake a pizza. If you accumulate all the ingredients & make the pizza base ready, 80% work is done here.
- So, when history fails to hint, you have to come to the real facts of the case. But does this mean analyzing every customer? Answer is no.
- 80-20 approach means 80% of total trade receivables are from only a few customers, which you can trace easily (say 2 out of 10 customers). So, this 20% of customers are regular & recurring customers. The question is recoverability from 80% of customers.
- The management can make a reliable estimate for bad debts from these customers & can create a provision.
Example of Bad Debt Reserve
Let’s say a company has the following receivables and the number of days the amount is due.
|Name of Debtors||Amount as of 31st December 2019 ($ in Million)||Ageing (Days)|
|Williams & Sons, Inc||1025||803|
The management has the following decision to make a provision
|Overdue in days||% Provision|
|More than 800 days||100%|
|More than 700 days||65%|
|More than 350 days||35%|
|More than 200 days||25%|
|More than 190 days||15%|
|More than 180 days||5%|
Provision for bad and doubtful debts as at 31/12/2019
|Name of Debtors||Amount as of 31st December 2019 ($ in Million)||Ageing (Days)||% Provision||Provision Amount ($ in Million)|
|Williams & Sons, Inc||1,025||803||100%||1,025|
- The management has estimated the percentage provision to be made.
- As you can observe, there is a NIL provision for less than 180 days & a 100% provision for more than 800 days of dues.
- Few companies are stricter. They apply 100% provision for 365 days due.
Bad Debt Reserve in Trial Balance
- The company makes provisions on the receivables amount as of a specific date. Such provision amount is recognized in the books as follows:
|Bad debts provision A/c (Debit)||XXXX|
|Bad debts reserve A/c (Credit)||XXXX|
- The “Bad Debts provision” account is an expense account (i.e., nominal account) with a debit balance. The account “Bad debts Reserve” is a liability account (i.e., personal account) having a credit balance.
- Each account will show the respective debit & credit balance in the trial balance.
- Thus, the trial balance is tallied to that extent.
Some of the advantages are given below:
- It is a provision by the management, i.e., an estimate & not a real fact. Thus, even if a provision is made, the amount is still recoverable for the entity.
- Netting off the reserve account helps the company understand its recoverable cash amount.
- In the case of actual bad debts, the reserve account is debited & the bad debts expense accounts are credited. Thus, actual bad debts will not impact the profits of the entity.
- Thus, consistency in profit figures can be maintained.
- It enhances the true & fair view of the entity’s financial statements.
- Creating a provision helps a company recognize the relevant bad debt in the relevant year. Thus, the matching principle has prevailed.
Some of the disadvantages are given below:
- The calculation part of estimating the provision for the year is difficult & lots of subjectivity is involved. The higher management of the company always questions subjectivity.
- The creation of a provision means recognition expense for that year. However, such expense is not allowed in taxable laws & liable to be disallowed.
- Actual bad debts can vary to any extent since there is an inherent risk of lower estimation.
- This is not an actual expense for the year & hence, some investors with no financial background can misinterpret it as a bad debt of the company.
Does creating a provision remove our right to recover from the customer? The rationale answer is NO. If the customer is willing to pay you after 2-3 years, you won’t say no to such incoming cash flow because you have made a provision against such a customer. Thus, provision is made only to prevent the profit & loss from getting a big hit (i.e., debit) on the company’s profits. Also, the auditors of any company will ask the client to make provisions if the realisation is doubtful.
This is a guide to Bad Debt Reserve. Here we also discuss the definition, how to calculate bad debt reserve, and advantages and disadvantages. You may also have a look at the following articles to learn more –