A bad debt allowance is an account that covers the portion of accounts receivable that may remain uncollected. Banks and businesses use it to minimize the chances of an interruption in operations due to unpaid and likely unrecoverable receivables. The balance in this account helps to cover losses incurred when a company or financial institution must write off a portion of receivables as bad debts.
Sometimes known as a loan loss reserve, a bad debt allowance is an account that is equal to the portion of accounts receivable that may ultimately remain uncollected from customers. Banks also make use of this type of provision, effectively protecting themselves from the possibility of losses that would otherwise jeopardize the financial institution’s ability to continue providing services to customers. In both scenarios, the idea of allowing a bad debt allowance is to minimize the chances of an interruption in operations due to unpaid and likely unrecoverable receivables.
In practice, the balance found in a provision account for bad debts helps to cover losses incurred when a company or financial institution must write off a portion of receivables as bad debts. Banks can choose to use the resources in this account when customers choose to abandon current accounts with negative balances. While writing off the negative balance as a loss, the loss is covered by funds contained in the bad debt allowance, a measure that helps to prevent the loss from impairing the bank’s ability to continue servicing other customers.
Banks also consider a bad debt allowance when it comes to loans. The amount of the provision depends on the total amount of loans that are active at a given time. By identifying the full face value of these loans, it is possible to use a formula to determine how much to keep in the bad debt allowance, a measure that allows the bank to remain solvent as long as the loss estimate is not exceeded and the balance of the loan loss reserve loans ran out completely. The exact formula used will vary, based on a number of factors, including historical data relating to losses incurred in recent years of operation.
A bad debt allowance works the same way with other types of businesses. For example, if a company extends credit to a customer and eventually defaults on the balance of that credit account, the amount will be deemed uncollectible after all reasonable means of collection have failed. At that point, the balance is considered a loss, and that loss is covered by the balance of the valuation account set aside to cover bad debts. To balance accounting records, funds are transferred from the bad debt account to receivables, enabling withdrawal of invoices associated with the abandoned and uncollectible credit account.
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