Calculate allowance for bad debts
Bad debts are customers (AR) that are unable to meet their commitment to pay for their service, product, or whatever widget they have received from you.
There is no set formula in terms of calculating your allowance or provision for bad debts. This often depends on your industry. A usual rule of thumb for this is 5% of your current debtors (AR). A business would often review their prior years’ financial statements to assess what an appropriate provision is.
Once this amount is calculated, you will create a provision in your balance sheet via the following journal entry.
DR: Bad debts
CR: Provision for bad debts
Once you have this provision, you would review it annually and assess whether it is acceptable in terms of the businesses tolerance level.
Share your thoughts
Now that you know your business needs to have a policy in place to implement AR, why do you think AR will be important in your sector?
Have you ever had any customer or client who could not pay you the owed amount?
Share your experiences and thoughts with your fellow learners in the Comments below.
Financial Analysis for Business Decisions: Cash Flow Management
Financial Analysis for Business Decisions: Cash Flow Management
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