how an allowance for bad debt works
lenders use an allowance for bad debt because the face value of a firm s total accounts receivable is not the actual balance that is ultimately collected ultimately a portion of the receivables will not be paid when a customer never pays the principal or interest amount due on a receivable the business must eventually write it off entirely methods of estimating an allowance for bad debtthere are two primary ways to calculate the allowance for bad debt one method is based on sales while the other is based on accounts receivable the sales method estimates the bad debt allowance as a percentage of credit sales as they occur suppose that a firm makes 1 000 000 in credit sales but knows from experience that 1 5 never pay then the sales method estimate of the allowance for bad debt would be 15 000 the accounts receivable method is considerably more sophisticated and takes advantage of the aging of receivables to provide better estimates of the allowance for bad debts the basic idea is that the longer a debt goes unpaid the more likely it is that the debt will never pay in this case perhaps only 1 of initial sales would be added to the allowance for bad debt however 10 of receivables that had not paid after 30 days might be added to the allowance for bad debt after 90 days it could rise to 50 finally the debts might be written off after one year requirements for an allowance for bad debtaccording to generally accepted accounting principles gaap the main requirement for an allowance for bad debt is that it accurately reflects the firm s collections history if 2 100 out of 100 000 in credit sales did not pay last year then 2 1 is a suitable sales method estimate of the allowance for bad debt this year this estimation process is easy when the firm has been operating for a few years new businesses must use industry averages rules of thumb or numbers from another business an accurate estimate of the allowance for bad debt is necessary to determine the actual value of accounts receivable default considerations