For most companies, calculating Bad Debt Reserves is not a super-complex affair, but should always be approached with a consistent methodology from period to period.
Generally Accepted Accounting Procedures (GAAP) requires that a Bad Debt Allowance (BDA), which is a forecast – an estimate of future bad debt write-offs, vs. just directly writing off bad debts as they occur.
The BDA can be estimated using one or a combination of factors, including:
- Your historical bad debt experience is a good starting point in evaluating up a general reserve to cover your typical Bad Debt Allowance (BDA) needs. However, you can do a better job by also considering other factors – below.
- Try an allowance of a percentage by aging bucket as you analyze your receivables; i.e, 0.5% of the 30 day column 0.75% of the 60 day column, and so on.
- In addition, outside your normal experience you might have major customers that are at risk of defaulting and going into bankruptcy. For this category, you should establish a specific reserve category for “named” customers.
- Your industry’s experience is instructive to make sure you are forecasting the right trend. Check public company competitors’ 10Ks to see how they are estimating their bad debt allowances and see bad debt trends.
You want to re-evaluate your BDA process annually and make adjustments based on your experience. Is your reserve too light, too high, or just right. It needs to be realistic.
As write-offs for actual bad debts occur, the BDA is credited with the amount of the write-off. A “bad debt” occurs when you have taken material steps to collect the amount owed and have realistically come to the conclusion that a debtor cannot pay its obligations.
The Journal of Accountancy covers this subject in greater depth should you want more information.