The proper use and estimation of bad debt reserves, also known as allowances for doubtful accounts, can help businesses avoid shocks to net profit caused by unpaid or underpaid obligations. Bad debt reserves are shown on a company's balance sheet as a line item underneath account receivables, the account it offsets or acts as a contra account to. Bad debt expense, the companion to bad debt reserves, shows on the profit and loss statement.

Bad Debt Reserve

A bad debt reserve is the amount that companies set aside to cover uncollectible receivables, notes or loans. Companies typically look at the past payment history of its customers and the ease or difficulty of collecting payments and use the average number or percentage to set their bad debt reserve. The key is accurate estimation. When a company estimates accurately, the company does not have to reduce net income when bad debts are written off.

Balance Sheet Effect

As a contra account to accounts receivable, subtract the bad debt reserve from the accounts receivable total. For example, your company generates $100,000 in quarterly revenues. Your bad debt reserve is 2 percent. Your balance sheet will show $70,000 in cash for payments received, $30,000 in accounts receivables and $2,000 in bad debt reserve. If these were your only short-term assets, your total net short-term assets would be $98,000 and your net receivables would be $28,000.

Net Income Effect

You would also charge $2,000 to bad debt expense, which appears on your income statement. As your company uses up or spends down its bad debt reserve, the release of that liability flows through your income statement. However, you do not adjust your income statement unless your actual bad debt expense exceeds your bad debt reserve or you recoup more payments than you had estimated and must reduce your bad debt reserves.

Example -- Balance Sheet

For example, part of the $30,000 in account receivables includes $10,000 one customer owes for services you delivered. However, your customer disputes the quality of your service and will only pay $9,500. You adjust your balance sheet by reducing the $10,000 accounts receivable to $9,500. This reduces your overall account receivables to $29,500. You also reduce the bad debt reserve from $2,000 to $1,500. Your net receivables remain the same at $28,000.

Example -- Income Statement

When you recognized the bad debt, the uncollected $500 was already reflected in the bad debt expense and therefore required no adjustment to your income statement. There was only a change in receivables and reserves but no change in net receivables because the two balance sheet line items offset each other.

Accrual Accounting

Bad debt reserves are only used in an accrual accounting system. If your business uses a cash accounting system, you record revenues when you actually receive the funds and record expenses when you pay them. In cash accounting, you would only record any actual bad debt expense on the income statement.