As a means of minimizing the impact of bad debt on the functionality of a company, the bad debt reserve is simply a means of creating a bank of reserve funds that help to offset accumulated bad debt. Typically, this bad debt is incurred when client invoices remain unpaid and there is not much chance of collecting on the outstanding invoices. Here are some different scenarios in which a bad debt reserve can make a positive impact.
One of the most common applications of a bad debt reserve is found within the business of factoring the Accounts Receivable for a company. Essentially, a factoring company purchases a bank of invoices from a corporation, with the understanding that the payments will be directed to the new owner of the invoices. The factoring company advances a large percentage of the face value of the invoices to the client, but retains a percentage to be earmarked in the event of bad debts. The percentage that is withheld is often calculated based on the average payment patterns that have been exhibited by past billing periods involving the same customers. Once all outstanding invoices for the period are paid and clear, the funds that were reserved to cover bad debt expenses is released and forwarded to the factoring company’s client.
Another example of the use of a bad debt reserve has to do with writing off bad debt incurred due bankruptcy or a client going out of business. Even when a company files for bankruptcy protection and an agreement is reached to allow creditors to receive a small percentage of the outstanding debt owed, there is usually a sizable amount of outstanding invoices that the vendor must write off. A bad debt reserve helps to ease the trauma of having to engage in writing off outstanding invoices as uncollected. Also, the action of using a bad debt reserve to cover these sorts of losses can also often be used as a deduction on annual tax returns, which helps to further ease the financial loss to the company.
Even a small business may occasionally have a client who is unable to honor an invoice for one reason or another. Having a bad debt reserve can be particularly important for the small business, since a large percentage of generated revenue tends to go for basic operations. When the collected revenue is a great deal less than the generated value of the invoices, a source of funds to make up the difference becomes crucial. Creating a bad debt reserve that is roughly equal to at least thirty days of operating expenses is an excellent way of safeguarding against the incidence of bad debt, and lessening the negative impact on the overall operation of the business.
