The bad debt reserve is used in the accrual method of accounting to adjust for projected losses from non-payment of loans or credit sales. This adjustment is necessary in accrual accounting because some credit sales will go bad even though revenue is recorded at the time of the sale regardless of when cash is received. There is no need for a bad debt reserve in the cash method of accounting because revenue is recorded only when cash is received.
Cash accounting is attractive for many small businesses because it is less complex and is an allowable Internal Revenue Service method for computing taxable income. However, cash accounting is not permissible under generally accepted accounting principles (GAAP). GAAP rules require the use of accrual accounting. Under GAAP, companies must follow “generally accepted accounting principles” in the preparation of financial statements, and when the company is publicly traded, the financial statements must be audited by certified public accountants.
Under accrual accounting, GAAP requires that revenue be recognized at the time the sale is made. GAAP also requires that bad debt be recognized and deducted from revenue during the same time period the revenue is generated. Because it is impossible to know precisely which accounts will turn bad, there are three GAAP procedures for estimating (forecasting) the allowance for bad debt: the percentage of credit sales method, the aging of accounts receivable method (a variation of the preceding) and the percentage of ending accounts receivable method. After you complete the computation, you report the allowance for bad debt on the balance sheet as a deduction from accounts receivable.
This is a historical method based on your company’s prior experience with uncollected accounts from credit sales. For example, your past experience indicates that, say, 5 percent of your total credit sales will go bad in any given accounting period. Accordingly, you would make a credit entry to your bad debt reserve on your balance sheet at the end of the period to adjust (reduce) your accounts receivable balance by 5 percent.
Aging assumes that the longer a receivable is outstanding, the greater the likelihood it will not be collected. This method applies a default percentage for each age bracket (for example, 30, 60 or 90 days past due). As with the total credit sales method, you base the percentages on historical data. However, the percentages are applied to each age bracket instead of to total credit sales.
This method requires an exercise in judgment by you, the business owner, or by your analyst after assessing the schedule of outstanding accounts receivable at the end of the period. It relies on your knowledge and evaluation of the outstanding accounts that will likely go bad. You compute that sum as a percentage of your ending accounts receivable balance, which reduces your balance by the same amount.
Many conservative business owners prefer setting large reserves to provide for unanticipated write-offs. However, this approach may be a way to understate true profits during the period the excessive reserve is accumulated. Regardless of the GAAP procedure you use for computing the allowance for bad debt, they all require your judgment as the business owner. The operating principle should be that of “reserve adequacy.”