Definition: Allowance for bad debt refers to the amount by which creditors may demand payment of debts when liquidation of assets (liquidation due to filing for bankruptcy) would result in an amount less than the amount owed. Allowance for bad debt is a valuation account for unpaid bills, disputed accounts, disputed payments, and other disputed assets. Values assigned to these items are based on estimates by disputing entities as to the individual’s creditworthiness whose assets are disputed. The purpose of the account is to aid in resolving disputed accounts, which can be a long-standing problem if the debtor is unable or unwilling to pay his or her debts.
When a borrower fails to make regular payments on a loan, the allowance for bad debt is included in the unpaid balance. The amount of allowance is based on the borrower’s income and financial status at the time of the loan. For example, if the borrower has very little money, such as making small loans to pay bills and other living expenses, there will be no allowance. On the other hand, if he or she has a high income but is earning less than expected because of recessions or economic problems, some money may be taken from the allowance to cover payments missed by past borrowers.
As a general rule, allowance for doubtful accounts is used first when assessing the amount of unpaid debt upon which a charge-off may be made against the firm. This allows the float created by the receivables of uncertain credit quality to be utilized before assessing whether an individual or business has satisfied his or her obligation to pay off the questionable debt through a due diligence process initiated through the use of an allowance for doubtful accounts.
The purpose of this account is to inform management regarding the volume and character of likely recoveries from disputed accounts, thereby enabling management to plan for recoveries more conservatively. Allowances for questionable accounts are useful for firms because they facilitate management using available resources to increase recoveries.
Allowance for Bad Debt Calculation
There are two methods to calculate the allowance for bad debt
- Sales method: The sales estimate for bad debts is negative, meaning the total amount of credit-related decline in a year is greater than the total amount of credit sales. This estimate is used to determine how much of a discount interest is owed on any future good debts that are allowed off.
- Account receiveable method: The allowance for bad debts provided by an account receivable is based on the estimated unpaid balance plus the estimated collection date (to the nearest 3 months), less any allowance for late payments. An account receivable with a high estimated unpaid balance may be considered current, even though it has not been paid in full; a low estimated unpaid balance will often be considered abandoned, and disposition rules may require that other creditors receive a portion of the unpaid balance as a settlement.
According to GAAP, the allowance for bad debt represents the amount of money that a company must pay if the cash-strapped company went into default. It is expressed as a percentage of total cash generated during a given period. So, for example, a bank may require an allowance of 10% of the cash generated during 12 months, or 20% if the company goes into default during that time frame. And, this isn’t the only consideration financial institutions consider when calculating the allowance for bad debt.
Allowance for bad debt estimates what the market will bear in the settlement of an account that has become due and past due. This estimate is essential to a company’s business operation, as it enables management to plan and adjust spending and earning priorities while minimizing disruption to the financial accounts of suppliers, contractors, and customers.
The basic principle is as follows: an account is past due if the unpaid balance exceeds the unpaid credit limit plus applicable interest and charges. In some cases, accounts receivable may be challenging to evaluate because the original obligation may no longer exist; for example, if a vendor has ceased business operations and asks you to pay for goods and services that they never provided.
The goal of the bad debt allowance is to recover as much of the money from the sale of bad debts as possible in accounting terms. Gaining access to credit, whether through a good or bad debt, typically requires collateral. The bad debt allowance gives you an opportunity to recover from bad debts once they have been incurred by someone else, whether it be through a personal loan or a company. Payment plans available through your credit card company may also offer an allowance.