Bad Debt Reserve - What is a bad debt reserve?

A bad debt reserve is an allowance set aside for any amounts that might not be paid by customers

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A bad debt reserve is an amount set aside to cover the losses that occur due to bad debt (customers not paying their bills). This reserve amount provides more stability to your company is estimated accurately, as it anticipates losses and can lessen the impact in your financial records because your net income will not be affected as significantly.

How it is determined

The amount allotted for in the bad debt reserve is based on historical or national norms for your product or industry and/or based on past experience with bad debt amounts.

That amount is then set aside under current assets to balance the expected percentage of bad debt for that accounting year.

A bad debt reserve is normally put in place at your financial year end once you have taken the view that any outstanding payments by customers will not be paid in the new financial year. This procedure is to avoid overstating the trade debtors which are amongst the assets of your business.

Why it matters

You many be aware of legal proceedings or serious disputes which could inhibit the payment by your customer so it is prudent to create a reserve for either the full amount or a proportion on the debt outstanding and place in the bad debt reserve account.

This practise can help you gain a larger picture of your company’s creditor behaviour. If you find your bad debt reserves increasing each accounting year, or significantly outside the historical norms, it can indicate poor choice of customers (those who are unreliable with payment).

A high amount allotted to bad debt can impact an investor’s interpretation of the company’s ability to work with reliable customers and to collect debt owed.