What is Allowance for Bad Debt?
An allowance for bad debt is essentially a reduction in a bank's accounts receivable. The allowance for bad debt equals the amount of the banks loans that it does not expect to collect.
How Does Allowance for Bad Debt Work?
Let's assume that Bank XYZ lends $1 million to 10 different borrowers. Accordingly, Bank XYZ increases its loan receivables by $1 million. One of those customers is Company ABC, which borrows $100,000.
If Company ABC suddenly declares bankruptcy or incurs cash flow problems and becomes very overdue in paying Bank XYZ, the bank may determine that all or some of the $100,000 Company ABC owes is uncollectible. Bank XYZ's balance sheet would then be adjusted to show $1 million of loans and $100,000 in an allowance for bad debt.
note that the allowance for bad debt is for amounts Bank XYZ suspects will not be repaid. When Bank XYZ in fact cannot collect the $100,000 (because Company ABC is liquidated, for example), Bank XYZ will record $100,000 on the income statement as bad debt expense (note that this reduces profits) and reduce the balance sheet's allowance for bad debt by the same amount.
How Bank XYZ determines that a loan is uncollectible is a matter of judgment and negotiation. In the real world, banks may not analyze the collectibility of every single loan when determining how much to record in their allowance for bad debt. Instead, they may simply use a percentage of loans or they may use a historical trend percentage.
Why Does Allowance for Bad Debt Matter?
Almost every bank records an allowance for bad debt because invariably some customers will fail to pay. However, changes in the allowance for bad debt can indicate other trends in a bank or even an economy.
For example, if the allowance has increased, the bank may be offering credit to riskier customers, which jeopardizes the reliability of the bank's cash flow. However, the bank also may be padding the allowance in order to make things look worse than they are -- because that can make future performance look better.