What is a Bad Debt Reserve?

The bad debt reserve is a provision for the estimated amount of bad debt that is likely to arise from existing accounts receivable. A large reserve may be caused by low-quality customers, which may in turn be caused by a company's reduced attention to screening the financial condition of prospective customers. Thus, a large bad debt reserve is ultimately caused by inattention to the corporate credit policy.

The concept of the bad debt reserve is mandated by accrual basis accounting, where all expenses associated with a sale transaction should be recorded at the same time as the revenue from the sale (known as the matching principle). Otherwise, bad debts might be recorded for months afterwards, resulting in an initial surge in profitability, followed by a long series of additional expenses that create sub-standard profits in later periods.

A bad debt reserve is a contra account, which is designed to offset the receivables account with which it is paired. The receivables account has a natural debit balance, while the bad debt reserve has a natural credit balance. The result is a net receivable balance reported in the balance sheet. For example, a balance sheet may reveal $1,000,000 of accounts receivable, against which is offset $50,000 of bad debt reserve. The net receivable balance is therefore $950,000.

The difficulty in using a bad debt reserve is how to estimate the amount of bad debt to record. This is typically derived by carrying forward a company's historical bad debt percentage, though this amount can be adjusted for more particular knowledge of the collection probability of specific receivables. Once derived, the accounting transaction is a debit to the bad debt expense account and a credit to the bad debt reserve. When a specific receivable is declared a bad debt, the accounting transaction is a debit to the bad debt reserve and a credit to the accounts receivable account.

Presentation of the Bad Debt Reserve

The bad debt reserve is designed to be an offset to the trade receivables account, with which it is paired on the balance sheet. If the balance in the reserve is relatively small, then the reserve may be aggregated with the total amount of accounts receivable, so that only a single receivables line item is reported on the balance sheet.

A bad debt reserve may also be created for other receivables, such as payroll advances to employees. Doing so is a conservative way to guard against possible shortfalls in these other types of receivables. When this is done, the amounts involved are usually so low that the reserve is merged with the associated receivable for presentation purposes.

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Bad Debt Reserve vs. Direct Write-Off Method

If a company elects not to use a bad debt reserve, it is instead choosing to use the direct write off method, whereby receivables are only written off when a specific receivable is declared uncollectible. There are several differences between these methods, which are as follows:

Impact on financial statements. The bad debt reserve presents a more accurate picture of net accounts receivable on the balance sheet by reducing it through the allowance for doubtful accounts. It also matches bad debt expense to the period in which the related sales revenue occurred, adhering to the matching principle. Conversely, when using the direct write-off method, accounts receivable remains overstated until the bad debt is written off.
Tax implications. The bad debt reserve is not typically accepted for tax purposes; tax authorities often require evidence of actual uncollectability. Conversely, the direct write-off method aligns more closely with tax regulations, as expenses are recognized when bad debts are demonstrably uncollectible.
GAAP compliance. The bad debt reserve approach is required under Generally Accepted Accounting Principles, because it adheres to the matching principle. Conversely, the direct write-off method is not GAAP-compliant, due to its failure to match expenses with related revenues.