Imagine you work at a company that provides credit to its customers. When you loan money to someone, there’s an inherent risk they won’t pay it back. This is called credit risk and is typically reflected in the loan's interest rate; the higher the risk level, the higher the interest rate.
In this scenario, what happens if the customer can’t pay back the loan they borrowed plus the interest they’ve accrued? Your company has what is called “bad debt.”
Bad debt is a reality for businesses that provide credit to customers, such as banks and insurance companies. Planning for this possibility by estimating the amount of uncollectible loans is called bad debt provision and can enable companies to measure, communicate, and prepare for financial losses.
Here’s how to account for doubtful and bad debt on financial statements, along with a primer on bad debt provision and why it’s important today.
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What Is Bad Debt?
Bad debt is the term used for any loans or outstanding balances that a business deems uncollectible. For businesses that provide loans and credit to customers, bad debt is normal and expected. There will likely be customers who can’t pay their debts back.
Because you can’t be sure which loans, or what percentage of a loan, will translate into bad debt, the accounting method for recording bad debt starts with an estimate. This estimate is called the bad debt provision or bad debt allowance and is recorded in a contra asset account to the balance sheet called the allowance for credit losses, allowance for bad debts, or allowance for doubtful accounts. It’s recorded separately to keep the balance sheet clean and organized. Often, estimated bad debt is referred to as doubtful debt.
Once doubtful debt for a certain period is realized and becomes bad debt, the actual amount of bad debt is written off the balance sheet—often referred to as write-offs.
If the actual bad debt was greater than the provision, the bad debt expense must be tracked on the income statement for the same accounting period during which the loan or credits were issued.
Accounting for a credit or loan agreement can be distilled into four key steps:
- Recording the credit agreement value
- Recording the cash collected from the customer
- Reporting the estimated uncollectible amount as allowance or provision
- Writing off the confirmed uncollectible amount
What Is Bad Debt Provision, and Why Is It Necessary?
The process of strategically estimating bad debt that needs to be written off in the future is called bad debt provision. There are several ways to make the estimates, called provisions, some of which are legally required while others are strategically preferred. Make sure to research the provisioning standards that apply to your locale.
One way to provision for bad debt is to understand the historical performance of loans in specific populations. This enables you to base your estimate on previous trends and back decisions with concrete data.
In the online course Financial Accounting, it’s explained that one strategy is to overestimate bad debt provision. This is a more conservative provision strategy and can be helpful in times of unexpected crisis. If your company’s bad debt exceeds the original estimate, you’ll be required to list it as a bad debt expense on your income statement. By making a more conservative provision, your company can avoid having to pay those expenses.
Bad Debt Provision to Prepare for Crisis
While it’s important for business professionals to understand bad debt provision in general, it’s an especially timely topic as the world fights the COVID-19 pandemic and numerous natural disasters.
External, uncontrollable circumstances can cause people not to repay their loans or credits. In such cases, businesses need to be prepared for the financial impact it could have on their bad debt expenses.
“When the environment changes—there’s a pandemic, there’s a recession, there’s a boom—different parts of accounting come into focus and acquire more salience,” says Harvard Business School Professor V.G. Narayanan, who teaches Financial Accounting.
Bad debt provision was recently added to the course content of Financial Accounting. Learn more from Professor Narayanan about its timeliness and the full course update in the video below.
Bad debt provision is important in times of crisis because it provides a financial buffer and protects businesses from being impacted too heavily by customers’ hardships. By making conservative provisions—estimating that a higher amount of doubtful debts will need to be written off in the future than have historically—you can prepare your business for the possibility of a crisis that causes more customers than usual not to repay their loans.
Striking a Balance
The discussion of bad debt provision strategy begs the question: Why not make bad debt provisions as high as possible? After all, estimating too low can result in bad debt expenses, and estimating overly high can prepare your organization for a possible crisis.
Having a high level of loans that don’t bring in a return on investment, also called non-performing assets (NPAs), reflects poorly on a company’s financial health and can turn away potential customers and investors. You want the majority of your loans and credit to be paid in full, on time, and with interest.
Bad debt provision strategy is about striking a balance between the minimum estimation and placing too much weight on potential crises that could happen but aren’t extremely likely to. Using historical data as a baseline is a wise place to start.
One example in Financial Accounting centers on a credit provider in India that typically provisions two or three percent higher than the minimum regulatory requirement for Indian companies. While the company regularly gets questioned by rating agencies and investors about its elevated level of NPAs, its reasonably conservative bad debt provision strategy allows it to have a low level of write-offs, well-maintained credit ratings, and the ability to keep the cost of capital low.
Developing Organizational Provisioning Standards
As you consider the importance of bad debt provisions and how to strike a balance between too low and too high, think about setting an organization-wide standard like the aforementioned example of the Indian credit provider. Having a set strategy for accounting for bad debt can streamline your organization and ensure all accounts comply with local provisioning standards.
If you’re interested in digging further into the specifics of bad debt provision, how it appears on financial statements, and how to further your provisioning strategy, consider taking Financial Accounting.
Are you interested in sharpening your financial accounting skills? Explore our eight-week online Financial Accounting course—one of three online courses that comprise the Credential of Readiness (CORe) program—to learn how strong accounting skills can enable you to meaningfully contribute to your organization and advance your career.
