What is an 'Allowance For Bad Debt'
An allowance for bad debt, also known as an allowance for doubtful accounts, is a valuation account used to estimate the portion of a bank's loan portfolio that may ultimately be uncollectible. When a borrower defaults on a loan, the allowance for bad debt account and the loan receivable balance are both reduced for the book value of the loan, or the outstanding loan balance. The allowance for doubtful accounts method is also used to record the accounts receivable that are not collectable.
BREAKING DOWN 'Allowance For Bad Debt'Lenders use the allowance for doubtful accounts method because the face value of a bank's total loan balance is not the actual balance that is ultimately collected, since a portion of the loans may default. When a borrower does not pay the principal or interest amount due on a loan, that loan is considered to be in default, and the allowance for doubtful accounts method accounts for the lender’s estimate of the loans that may default.
How a Lender Accounts for Loan Losses
Assume, for example, that a lender has a $100 million loan portfolio, and the company uses the allowance for doubtful accounts method for bad debt. The lender estimates that 2%, or $2 million of the loan balance is at risk of default, so the firm increases bad debt expense in the income statement, and the allowance for doubtful accounts is increased by $2 million. The allowance for doubtful accounts is a contra-asset account, meaning that the allowance account reduces the loan receivable account when both balances are listed in the balance sheet. This financial reporting helps the reader understand the amount of loans that may default. Lenders also refer to this entry as a provision for loan loss, and some lenders may use slightly different accounts titles.
Factoring in Defaults
When a lender confirms that a specific loan balance is in default, the company reduces the allowance for doubtful accounts balance and reduces the loan receivable balance, because the loan default is no longer simply part of a bad debt estimate. After this entry, the accounting records have a balance in bad debt expense and a reduction in the loan receivable balance for the loan that actually defaulted.
Instances in Which the Allowance Account Is Adjusted
The allowance for doubtful accounts always reflects the current balance of loans that are expected to default, and the balance is adjusted over time to show that balance. If, for example, a lender estimates that $2 million of the loan balance is at risk of default, and the allowance account already has a $1 million balance, the adjusting entry to bad debt expense and to increase the allowance account is an additional $1 million.