A bad debt provision is an accounting provision that allows businesses to absorb uncollected revenue, creating a cushion to minimize the impact of uncollected debt. The amount is determined based on factors such as average accounts receivable and age of customer invoices, and is considered part of accounts receivable. It is especially important for small businesses to have a bad debt allowance to protect their credit rating and relationships with vendors. Periodic evaluation is necessary to adjust the allowance based on changes in factors such as loan payments and customer payment speed.
Also known as a bad debt provision, a bad debt provision is an accounting provision that makes it possible for a business to absorb a certain amount of revenue that remains uncollected from invoices sent to customers, or from overdue loans issued by the business. The idea of making this type of allocation is to create a small cushion that helps minimize the effect of 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 bad debt reserve based on the average amount of accounts receivable held each month. For example, if a business typically has an average monthly accounts receivable of $500,000 in United States dollars (USD), the allowance might be set at around 5%, or $25,000 USD. Other factors, such as the average age of customer invoices, may also be taken into account. If several larger customers routinely pay invoices in sixty to ninety days, rather than the thirty to forty-five day range, this may affect the percentage used to calculate the allowance.
Whatever the amount of the bad debt allowance, the figure is still considered part of accounts receivable, and is recorded in that part of the accounting records. However, the company will try to always keep that same amount available in the operating account. If the worst case scenario occurs, and the full amount of the allocation is not collected in a given month, the company’s ability to meet its own debt obligations remains relatively unaffected. This means that the allowance provides a function similar to a contingency or emergency fund that is set aside as part of a household’s budget.
Operating with a bad debt allowance is especially important for small businesses. Since it’s not unusual for businesses of this type to operate on a shoestring budget, failing to build some sort of buffer into the accounting process could have dire consequences if multiple customer invoices remain uncollected and eventually have to be written off as uncollectible. By positioning the business so that it can pay its operating expenses on time, even if a portion of the accounts receivable is deemed uncollectible, the company protects its credit rating and its relationships with various vendors and vendors.
A periodic evaluation of the current allowance for bad debts is necessary. This can be done by analyzing data such as the average monthly amount of accounts receivable, the rate at which loan payments are received, and how quickly customers remit payments on outstanding invoices. When those factors change, the award figure could also change, depending on the extent of the change.
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