Harness Money

What is allowance for bad debt?

An Allowance for Bad Debt, also known as an Allowance for Doubtful Accounts, is an accounting term that refers to the estimated amount of money a company sets aside to cover potential losses from customers who may not be able to pay their debts. It is a provision made by a company to account for the possibility of non-payment or partial payment by customers.

The purpose of the allowance is to match the expenses related to potential bad debts with the revenues they are associated with. It follows the principle of conservatism in accounting, where potential losses are recognized in advance to ensure accurate financial reporting.

To create the allowance, a company assesses its outstanding accounts receivable and identifies customers who may have difficulty paying their debts. Factors considered may include the customer’s payment history, financial stability, industry conditions, and any specific circumstances that could affect their ability to pay.

The company then estimates the percentage of these outstanding amounts that may ultimately prove uncollectible and records that estimated amount as an expense in the income statement. The corresponding entry is made to the allowance for bad debt account, reducing the overall accounts receivable on the balance sheet.

Over time, as actual bad debts are identified and specific customers default on their payments, the company writes off those amounts from the accounts receivable and reduces the allowance for bad debt accordingly. This process ensures that the financial statements reflect a more accurate representation of the company’s expected losses from non-payment.