Legal Definitions - bad-debt reserve

A bad-debt reserve is an accounting measure used by businesses to set aside an estimated amount of money that they expect not to collect from customers who owe them money. It's an allowance for doubtful accounts, meaning it's a provision made to account for the risk that some outstanding invoices or loans will never be paid.

Businesses create a bad-debt reserve to present a more accurate picture of their financial health. Instead of assuming all money owed will be collected, they realistically anticipate that a certain percentage will become uncollectible, thereby reducing the reported value of their accounts receivable (money owed to them).

• Example 1: A Large Online Retailer

  An online retailer offers its customers a store credit card. While most customers pay their monthly bills on time, the retailer knows from experience that a small percentage will default on their payments due to various reasons like job loss or bankruptcy. To reflect this reality, the retailer establishes a bad-debt reserve. Each month, they might add a percentage of their new credit sales to this reserve. If, for instance, they have $10 million in outstanding credit card balances and historically 2% are uncollectible, they might set aside $200,000 in their bad-debt reserve. This ensures their financial statements show a more accurate value of the money they realistically expect to collect from their credit card customers.

• Example 2: A Business-to-Business (B2B) Software Company

  A company that sells subscription-based software to other businesses often invoices its clients quarterly or annually. While they have contracts in place, some client businesses might go bankrupt, merge, or simply refuse to pay for services rendered due to disputes. Based on past experience with hundreds of clients, the software company anticipates that about 1% of its total outstanding invoices will never be collected. Therefore, they maintain a bad-debt reserve. If they have $5 million in accounts receivable from their clients, they might allocate $50,000 to this reserve. This accounting practice helps them avoid overstating their assets and provides a more conservative and realistic view of their expected cash inflows.

• Example 3: A Medical Practice

  A large medical clinic bills patients and their insurance companies for services. Even after insurance payments, patients often have co-pays, deductibles, or uncovered services they are responsible for. The clinic finds that a certain portion of these patient balances are never fully paid, either because patients forget, dispute charges, or face financial hardship. To account for these expected losses, the clinic maintains a bad-debt reserve. For example, if they have $1 million in patient balances outstanding and historical data shows 10% of these are uncollectible, they would set aside $100,000 in their reserve. This allows them to report a more accurate net amount of receivables they genuinely expect to receive, rather than the full amount billed.