The bad debt reserve is a provision for the estimated amount of bad debt that is likely to arise from existing accounts receivable. A large reserve may be caused by low-quality customers, which may in turn be caused by a company's reduced attention to screening the financial condition of prospective customers. Thus, a large bad debt reserve is ultimately caused by inattention to the corporate credit policy.
The concept of the bad debt reserve is mandated by accrual basis accounting, where all expenses associated with a sale transaction should be recorded at the same time as the revenue from the sale (known as the matching principle). Otherwise, bad debts might be recorded for months afterwards, resulting in an initial surge in profitability, followed by a long series of additional expenses that create sub-standard profits in later periods.
A bad debt reserve is a contra account, which is designed to offset the receivables account with which it is paired. The receivables account has a natural debit balance, while the bad debt reserve has a natural credit balance. The result is a net receivable balance reported in the balance sheet. For example, a balance sheet may reveal $1,000,000 of accounts receivable, against which is offset $50,000 of bad debt reserve. The net receivable balance is therefore $950,000.
The difficulty in using a bad debt reserve is how to estimate the amount of bad debt to record. This is typically derived by carrying forward a company's historical bad debt percentage, though this amount can be adjusted for more particular knowledge of the collection probability of specific receivables. Once derived, the accounting transaction is a debit to the bad debt expense account and a credit to the bad debt reserve. When a specific receivable is declared a bad debt, the accounting transaction is a debit to the bad debt reserve and a credit to the accounts receivable account.
The bad debt reserve is designed to be an offset only to the trade receivables account. However, a similar contra account could be constructed for other receivables, such as payroll advances to employees, that reserves against possible shortfalls in these other types of receivables.
If a company elects not to use a bad debt reserve, it is instead choosing to use the direct write off method, whereby receivables are only written off when a specific receivable is declared uncollectible. As noted earlier, writing off receivables in this manner is not considered to be the best accounting, since expense recognition is delayed. Auditors may refuse to certify the financial statements of a company that uses the direct write off method, unless the business first switches to a bad debt reserve.
The bad debt reserve is also known as the allowance for doubtful accounts, the bad debt provision, and the doubtful debts provision.