What is a 'Bad Debt Reserve'

A bad debt reserve is the dollar amount of receivables that a company or financial institution does not expect to actually collect. This includes business payments due and loan repayments.

Also known as an allowance for doubtful accounts (ADA)

BREAKING DOWN 'Bad Debt Reserve'

A bad debt reserve is a valuation account used to estimate the portion of a company's accounts receivables or a bank's loan portfolio that may ultimately default or become uncollectible. There are two benefits from this reserve.

For accounting purposes, the bad debt reserve allows the company or bank to state the face value of its receivables or loans. The reserve resides in a different area of the balance sheet so the net result is that the value of receivables / loans reflects their expected value. Of course, should some of the bad debts pay, the result is a bump to the bottom line.

The second benefit is a margin for error with regard to planning cash flows. If the company is prepared for a default then it will not be as affected from it.

When a specific receivable or loan balance is actually in default, the company reduces bad debt reserve balance and reduces the receivable balance, because the 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.

If a company has $1 million in receivables but one of its customers, which owes $50,000, is undergoing problems in its own business, the company might push the entire $50,000 to bad debt reserve. It still has $1 million in receivables but expects that in the end it will only be worth $950,000.

How much a company keeps in reserve depends on the company, management and the industry it is in. Some use a simple percentage of sales or a historical average. An alternative could be based on the debt's age with the older debts less likely to pay. In some cases, a company might rate each customer individually. Still others might use a combination of a percentage plus scrutiny of its riskiest accounts.

Bad debt reserves as a health measure

Most companies and banks keep a bad debt reserve because some percentage of customers will fail to pay. Analysts keep track of changes in bad debt reserves, which can uncover other financial health problems in a company. This includes how effectively a company manages the credit it extends to customers.

For a company, the most glaring problem might be a sharp increase in the reserve as it does business with riskier customers. This could jeopardize the company's cash flow.

On the other end of the spectrum, the company may be pad its reserves now to give off a weaker current condition. Future performance would look better, in contrast.

  1. Allowance For Bad Debt

    An allowance for bad debt is a valuation account used to estimate ...
  2. Bad Debt Expense

    A bad debt expense is a receivable that is no longer collectable ...
  3. Allowance For Credit Losses

    Allowance for credit losses is an estimation of the debt that ...
  4. Bad Bank

    A bad bank is one that is set up to buy the bad loans of another ...
  5. Debt

    Debt is an amount of money borrowed by one party from another, ...
  6. Net Debt

    Net debt is a metric that shows a company's overall debt situation ...
Related Articles
  1. Investing

    Will Corporate Debt Drag Your Stock Down?

    Corporate debt can mean a leg up for firms, or the boot for investors. How to tell the difference.
  2. Insights

    How Countries Deal With Debt

    For many emerging economies, issuing sovereign debt is the only way to raise funds, but things can go sour quickly.
  3. Personal Finance

    An Advisor’s Take: What to Pay Off First

    When you are dealing with mortgages, auto loans and student loans, you need a strategy for debt repayment that addresses multiple types of debt.
  4. Personal Finance

    Best 5 Money-Saving Tips to Get out of Debt

    Understand the different types of debt and the reasons why people get into debt. Learn about five tips to follow to get out of debt.
  5. Insights

    The National Debt Explained

    We know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
  6. Personal Finance

    Is Debt Really a Bad Thing to Have?

    Not all debt is bad. Good debt is that which is incurred to increase your future income.
  7. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  8. Investing

    Debt Ratio

    The debt ratio divides a company’s total debt by its total assets to tell us how highly leveraged a company is—in other words, how much of its assets are financed by debt. The debt component ...
  9. Personal Finance

    How Poor Credit Hurts You as an Investor

    Bad credit can hurt you as an investor and potential homeowner, but you can make things right.
  10. Personal Finance

    The Generational Debt Gap

    Are future generations in trouble when it comes to how much debt they have? We compare debt between other age groups to find out.
Trading Center