Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Bad Debt Reserve

What it is:

Bad debt reserve, also called an allowance for doubtful accounts (ADA), is a reduction in a company's accounts receivable. The bad debt reserve is the amount of receivables that the company does not expect to actually collect.

How it works (Example):

Let's assume that Company XYZ sells $1,000,000 worth of goods to 10 different customers.  Company XYZ records $1,000,000 in revenue on its income statement and $1,000,000 in accounts receivable on the balance sheet (we are assuming the customers have 60 days to pay). 

Company XYZ discovers that one of its customers, Big Store, is not doing very well. Big Store stops paying its bills and doesn't pay Company XYZ for $100,000 worth of goods. Company is not confident that Big Store will ever pay, so it categorizes the $100,000 as a bad debt. Company XYZ adjusts its balance sheet to show $1,000,000 in accounts receivable and $100,000 in bad debt reserves, for a net accounts receivable of $900,000.

Note that the bad debt reserves account is only for receivables Company XYZ suspects will not be collected. If Company XYZ, in fact, cannot collect the $100,000 (for example, if Big Store is liquidated), Company XYZ will record $100,000 on the income statement as bad debt expense and reduce the bad debt reserves by the same amount.

How Company XYZ determines that a receivable is uncollectible is a matter of judgment and negotiation. In the real world, companies may not analyze the collectibility of every single account when determining how much to record in their bad debt reserve. Instead, they may simply use a percentage of sales or accounts receivable, or they may use a historical trend percentage.

Why it Matters:

Almost every company records a bad debt reserve because invariably some customers will fail to pay. However, changes in bad debt reserves can indicate other trends in a company. A thorough analysis of bad debt reserves over time can provide extremely valuable insights into how effectively a company is managing the credit it extends to customers.

For example, if the reserve has increased dramatically, the company may be offering credit to riskier customers, which jeopardizes the reliability of the company's cash flow. On the other hand, the company may be padding the reserve in order to make things look worse than they are, because that could make future performance look better.