An allowance for bad debts is used to reduce accounts receivable by the number of accounts unlikely to be collected, providing a more accurate financial picture. Companies must be consistent in calculating this figure to maintain financial statement integrity. Writing off bad debt allows companies to claim an expense and reduce tax liability. Underestimating this figure can create problems and potentially mislead investors.
An allowance for bad debts is an entry on a balance sheet to reduce the total accounts receivable by the number of accounts that the company is unlikely to be able to collect, canceling the bad debt. This provides a more realistic picture of a company’s finances by avoiding a situation where you exaggerate the amount of accounts receivable to make it look like more money is coming in. Accountants can use various methods to arrive at this figure, and they must be consistent in how they calculate it to maintain the integrity of the financial statements.
One way to handle uncollectible accounts is to treat them as accounts receivable until it’s clear they’ll never pay. The problem with this method is that companies can exaggerate the revenue they expect to receive. With an allowance for bad debts, the company determines the average number of accounts that go into default and records it on the balance sheet as a “contra asset” to offset the accounts receivable. This allows companies to anticipate bad debt write-offs by accounting for them as soon as possible.
A mortgage lender, for example, expects a certain percentage of loans to default. He determines this allowance each month, based on the number of new mortgages he issues to write down accounts receivable immediately, rather than waiting for those accounts to become delinquent. This allows the company to provide a more accurate picture of your financial health.
Once it becomes apparent that individual accounts are delinquent and the company cannot wait for repayment, it can write them off and officially classify them as bad debt. This allows the company to claim an expense in the form of bad debt, which allows it to reduce its tax liability. It can take months of negotiating a delinquent account before making the decision to classify it as bad debt. Thanks to the bad debt allowance that the company uses in its financial statements, default is already accounted for in the company’s accounts receivable statements.
If a company underestimates this figure, it can create problems. The company may be reluctant to write off some delinquent accounts, fearing these statements will push its financial statements into the red. He could also be charged with inflating its financial health to mislead shareholders and other investors, a potentially serious charge if the people can show the company knew its estimates were off and chose to continue using them.
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