Accurately forecasting uncollectible accounts is one of the key challenges facing credit professionals since the 2002 enactment of the Sarbanes Oxley Act (SOX).

The passage of SOX has resulted in a federal mandate requiring companies to accurately determine and report the value of all assets. Public companies, required by law to comply with SOX, are not alone in facing increased examination of their valuation and reporting methods. Sarbanes-Oxley has become the standard for best practices in financial accountability across the board. Thus, banks and venture capitalists often hold private companies to the same stringent criteria.

The single largest liquid asset of many companies is its accounts receivable (A/R). As a result, the valuation and methodology used to determine the value of this asset has come under increased scrutiny. Calculating and establishing a Bad Debt Reserve provides an accepted method for dealing with accuracy and reporting requirements.

What Is a Bad Debt Reserve?

The bad debt reserve is a bookkeeping account utilized by a company to offset losses resulting from non-payment of outstanding loans. For most companies, other than banks and certain financial institutions, these loans represent sales on credit.

When is a Bad Debt Reserve Necessary?

If you’re using the Cash Method of accounting, income is only recorded when the payment is actually received, so there is no need for a reserve account to offset future bad debt.

However, under GAAP (Generally Accepted Accounting Principles) requirements and for SOX compliance, the Accrual Method of accounting must be used. This accounting method recognizes income when the credit sale is made (before it is paid). Accrual accounting also requires that bad debts be recognized as an expense in the same period as the revenue was generated. Without a crystal ball, credit analysts have no way of knowing at the outset which accounts are going to go bad. Therefore, it’s necessary to have a means of forecasting (or estimating) the amount of bad debt that will occur.

How Are Bad Debt Reserves Calculated?

The bad debt reserve is typically adjusted on a monthly basis. There are three generally accepted procedures for calculating the reserve amount:

Percentage of Ending Accounts Receivable. At the end of each period, the analyst (or automated system) looks at the outstanding receivables and estimates the percentage that will not be collected. The Reserve is then adjusted to equal that percentage.
Percentage of Credit Sales. An historical percentage, based on the bad debt experience of the company itself and/or its industry is applied to all credit sales.
Percentage by Aging of Accounts Receivable. A default percentage is determined for each age bucket (age past due), again based on company or industry historical data. At the end of each period, the analyst looks at the aging of outstanding receivables and applies the appropriate percentages. This is considered more precise than using the percentage of ending accounts receivable described above.

Example of Method #3:

For industry bad debt information, let’s use the CLLA’s (Commercial Law League of America’s) Probability of Collectability chart. Note: as this chart reflects data on claims already placed for collection, the bad debt percentages for the younger debts will be considerably higher than an actual creditor would experience. However, as the accounts reach a more advanced age, the loss percentages used here will become more realistic.

Sample Reserves Based on A/R Aging

	Current	30 Days	60 Days	90 Days	6 Mos.	9 Mos.	1 Year	2 Years	Total
A/R Balance	1,000	400	250	200	75	300	50	120	2,400
Loss %	1.8	6.9	14.6	26.9	50.0	59.6	75.0	89.5
Reserve	18.00	27.60	36.50	53.80	37.50	178.80	37.50	107.40	497.10

Based on this example, this company would need to establish a $497.10 bad debt reserve on its total $2,400 receivables.

Three-Pronged Approach to Setting Bad Debt Reserve

In Covering Business Credit, business consultant, Dorothy Siegel, recommends utilizing a three-pronged approach to setting a bad debt reserve:

General reserve based on an historical percentage of prior year’s sales.
Specific reserve for problem accounts, including bankruptcies and accounts placed for collection.
High-risk reserve for accounts considered risky, like slow pays, highly leveraged accounts, disputed accounts, etc.

Other Conditions that Can Affect the Reserve Percentage

Other than historical information, there are a number of other factors that can impact the determination of the reserve percentage. For instance:

General economic environment
Domestic vs. international receivables
Size of receivables
Security/collateral
Length of your relationship with the customer

Accounting for the Bad Debt Reserve

The Allowance Method is used in reporting the bad debt reserve on the company’s balance sheet. To do so, a “contra asset account” is created on the Expense side of the balance sheet. The amount calculated as the bad debt reserve is entered into this account, and offsets the Income side of the sheet which records the entire amount of credit sales.

You might think of the contra asset account as a kind of virtual savings account whereby a company can “pay” itself back for bad debt. The account is virtual, as it doesn’t represent a real exchange of cash, but rather movement from one side of the bookkeeping ledger to the other.

Important Note: The Tax Reform Act of 1986 repealed the use of the Allowance Method of accounting for bad debt for tax purposes. Corporations may only take tax deductions for bad debt at the time the specific uncollectible account has been identified. Therefore, for tax purposes, the Direct Write-Off Method must be used by which bad debt is expensed only at the time the customer actually defaults.

Value of the Bad Debt Reserve

When a reserve for uncollectible accounts is calculated accurately, it provides a number of benefits to the organization beyond the achievement of Sarbanes Oxley compliance.

It provides an estimate of cash flow that can be expected in the near future.
It helps to make the Profit and Loss statement more accurate, for accountability purposes.
It ensures that the company’s net income, as reported to shareholders, is not overstated and will not be unexpectedly reduced when unpaid receivables are actually written of as uncollectible.

Sources of More In-Depth Information on Calculating and Accounting for Bad Debt Reserves

Accounts Receivable and Bad Debts Expense, PowerPoint™ presentation by Doug Hillman

Evaluating Accounts Receivable, CliffsNotes

Determining Bad Debt Reserves and Accounting for Bad Debts, Publication of the Credit Research Foundation ($10.00)

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