Also known as an allowance for doubtful accounts, an allowance for bad debt is an accounting provision that makes it possible for a business to absorb some amount of revenue that remains uncollected from invoices sent to customers, or from past due loans issued by the business. The idea of making this type of allowance is to create a small cushion that helps to minimize the effect of the uncollected debt on the financial well-being of the company. Both small and large businesses make this allowance as part of the ongoing accounting process.
In many cases, the business will determine the amount of the allowance for bad debt based on the average amount of accounts receivable that is carried each month. For example, if a company usually has an average receivables each month of $500,000 in US Dollars (USD), the allowance may be set at around 5%, or $25,000 USD. Other factors may also be taken into consideration, such as the average aging of customer invoices. If a number of larger customers customarily pay invoices between sixty and ninety days, rather than in the thirty to forty-five day range, this may affect the percentage used to calculate the allowance.
Whatever the amount of the allowance for bad debt, the figure is still considered part of the receivables, and is accounted for in that portion of the accounting records. However, the business will attempt to always keep that same amount on hand in the operating account. If the worst case scenario comes to pass, and the total sum of the allowance is not collected in a given month, the ability of the company to honor its own debt obligations remains relatively unaffected. This means that the allowance provides a similar function to a contingency or emergency fund that is set aside as part of a household budget.
Operating with an allowance for bad debt is especially important for small businesses. Since it is not unusual for businesses of this type to operate on a shoestring budget, failing to build some sort of cushion into the accounting process could have dire consequences if several invoices to customers remain uncollected and eventually have to be written off as uncollectable. By positioning the business so that it can still pay its operating expenses on time, even if a certain portion of the receivables is deemed uncollectable, the company protects its credit rating and its relationships with various vendors and suppliers.
Periodic evaluation of the current allowance for bad debt is necessary. This can be performed by analyzing data like the average monthly amount of the receivables, the rate at loan payments are received, and how quickly customers are remitting payments on outstanding invoices. When those factors change, the figure for the allowance could also change, depending on the extent of the shift.