The Risks of Using Bad Debt Reserves

The Risks of Using an Allowance for Doubtful Accounts

What Is an Allowance for Doubtful Accounts (ADA)?

An allowance for doubtful accounts, also known as dummy bad debt reserve, is money set aside by a company to cover receivables that might not be paid by their customers over a given time period. It's the total amount of receivables the company never expect to collect

How Do You Calculate an Allowance for Doubtful Accounts?

To establish an adequate allowance for doubtful accounts, a company must calculate its bad debt percentage. To make that calculation, divide the amount of bad debt by the company’s total accounts receivable for a period of time and then multiply that number by 100.  

(Amount of bad debt/ Company’s total accounts receivable) X 100 = Percentage of bad debt 

Using this calculation, if a company has $100 million in their accounts receivable in a given year, and $5 million of that amount cannot be collected from customers, that company’s percentage of bad debt would be five percent. This is known as the direct write-off method and reveals the exact bad debt percentage.

However, many in the financial industry avoid using this calculation method because of the length of time that can elapse between a sale and the determination that a debt is uncollectible. This lag can throw off a company’s accounts receivable numbers on a balance sheet.

Instead of the bad debt reserve calculation, companies may use the allowance method, which anticipates that some of a company’s existing debt will be uncollectible and accounts for that prediction right away.

How to Write off Doubtful Accounts

Writing off doubtful accounts means accepting that some accounts receivable will never be collected and rectifying accounts accordingly. There are primarily two methods for writing off bad debt. Using the direct write-off method, you would debit an uncollected amount to a bad debt account and credit your accounts receivable account for the same amount once the amount has been deemed uncollectable. For the provision for bad debt write-off method, you would estimate all bad debt at the end of each accounting period, debit it to a bad debt account and credit your accounts receivable account.  

Direct Write Off Method

The direct write off method uses actual amounts of uncollected debt from accounts receivable and is the only method accepted by the IRS for reporting taxable income. The amount of the bad debt is offset by a credit memo for the unpaid account, debiting the bad debt expense account and crediting the accounts receivable account.

The direct write off method is considered aggressive accounting. It adds a significant delay between recognizing revenue from a transaction and identifying all expenses connected with that same transaction. Before the doubtful account is written off, the profitability of the transaction in question appears higher than it will be when the bad debt expense is finally added.

Allowance Method

The allowance method is considered a less aggressive and, in some industries, more acceptable method for writing off debt. It relies on the premise that the amount of bad debt can be accurately estimated based on historical accounting data. Using this estimate, a reserve is set aside for future bad debts. A transaction and its related bad debt expense are then recorded in the same time period, making the financial statements a more accurate record of transaction profitability.

How to Estimate an Allowance for Doubtful Accounts

Companies may base their need for a reserve for bad debts on estimations from previous years’ bad debt percentages or economic factors affecting their business. For example, economic improvements may lead companies to anticipate a smaller bad debt than previous years, while recessions, geopolitical or market instability, or other negative economic factors may push their prediction higher than a previous year. 

Other factors a company might consider in their bad debt reserve prediction include the size of the potentially dummy uncollectible receivables they are trying to account for, any collateral the customer may be able to offer, the length of the customer relationship, and any recently implemented changes in credit policies. If a company operates across multiple global markets or industries, each category of customer will need to be evaluated separately to formulate a valid prediction. 

The bad debt reserve calculation a company comes up with helps its financial team better manage doubtful accounts and dummy cash flow.However, these calculations can become complicated and even inaccurate if unpredictable events arise and cause major impacts on a company’s cash flow.

Why Doubtful Accounts Expenses Matter

Allowances for doubtful accounts  are an important tool to help cover inevitable dummy non-payments. However, increasing or frequently changing bad debt reserves may point to problems with a company’s financial health and creditor behavior. If a company finds it is usually increasing reserves, it should take a look at its customers and determine if any are too risky or unreliable to warrant a continued relationship.

In addition, the company should re-examine how it manages credit extended to customers. If the company’s bad debt reserve is too high, investors may lose confidence in the company’s ability to work with a reliable customer base and ensure collection for products or services provided.

Are Provisions for Doubtful Accounts a Good Idea?

One common area where companies fail to evolve is in continuing to own their own risk when it comes to insuring their dummy accounts receivable. In these instances, business owners agree to accept the loss of any unpaid invoice amounts, plus the full costs required to manage their internal credit grading processes. These businesses use a bad debt reserve to offset losses, research customers of their own and own all the risk internally.

Self-insuring by using allowances for doubtful accountsbad debt reserves may come without a direct cost, but it offers limited benefits in the event of a catastrophic loss. Remember, unpaid invoices weaken your cash flow and those additional costs will add up quickly. Utilizing an allowance for doubtful accounts if a customer doesn’t pay also requires more internal resources to manage the risk. Use the comparison chart below to see how much you might be costing your business.

credit insurance vs. allowance for doubtful accounts

Trade Credit Insurance (TCI): A Better Alternative to Bad Debt Reserves

Trade credit insurance protects your business from non-payment of commercial debt, making sure invoices are paid, and allowing you to reliably manage the dummy commercial and political risks of trade beyond your control. It protects your capital, maintains your cash flows, and—most importantly—secures your earnings against defaults. When compared to self-insurnace, TCI provides you with a safer, more strategic accounts receivable management option. To break it down further, take a look at how both approaches compare for various aspects of your business.

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Feature Allowances for Doubtful Accounts (Self-Insurance) Trade Credit Insurance
Coverage Any loss. You can recover one dollar for every dollar you reserve Insolvency, protracted default, and political risks. Maximum liability at +/- 50x premium so your dollar goes 50 times farther
Services Internal resources Credit information, risk assessment, market intelligence, debt collection
Financing None, but often required by financing sources Typically allows foreign receivables and other exclusions to be added back into your borrowing base
Customer Relationships Maintain a direct relationship with the customer Buyer is unaware of the credit insurance contract; better terms enhance the relationship with the customer

Find a Solution with Allianz Trade

How many opportunities are you missing by self-insuring your business with an allowance for doubtful accounts? With soft costs affecting your bottom line, could you realize increased efficiencies by allowing trade credit insurance to handle the risk while you put that money to work?

Allianz Trade can help companies that rely on bad debt reserves transition to the safer option, trade credit insurance. We have solutions available for any business at any size. Partnering with us allows you to offer your customers faster credit limit extensions with access to ongoing monitoring of your customers, and more. Try one of our tools below to see how much ROI trade credit insurance can add to your business or get a free quote