Question

How does a Treasurer set the appropriate amount to keep in the balance of the Bad Debt Reserve account? What is the purpose of keeping a reserve for Bad Debt (or any reserve)? Which departments want the Bad Debt reserve kept as low as possible and which want the reserve to be kept as high as allowable? Why do these departments feel their opinion about the reserve is the best way?

Answer 1

How does a Treasurer set the appropriate amount to keep in the balance of the Bad Debt Reserve account?

The treasures has two methods as detailed below:

1] Set the bad debts reserve amount as a specific percentage of the credit sales. The percentage can be based on past experience.

When such a system is adopted, each year the specified % of credit sales is created as reserve. All bad debts write off would be against the amount so set. Every year the balance available is carried forward to the next year.

When such a method is followed, there is no specified amount which is to be kept in the reserve account. What is credited less the writeoffs, gets carried over to the next year.

2] On the basis of aging of AR:

Under this method, the ending balance of AR is classifed as outstanding for different periods of time, like 0 to 30 days, 31 to 60 days, etc. Against each class a % is specified as the likely bad debts that may arise. Applying the specified percentages to each class and totalling them would give the balance that should be in the reserve account. Adjustment entries are made to adjust the undadjusted balance to the amount required as reserve.

What is the purpose of keeping a reserve for Bad Debt (or any reserve)?

The purpose is to relate bad debts expense to the period during which the sale is made, though the bad debts might arise in subsequent years. This is done to satisfy the matching principle, which, says that income arising during a period should be matched with the expenses of the period.

If bad debts are directly written off without creating a reserve account, the bad debts expense may relate to previous period sale and then the matching concept would be flouted.

The creating of reserve by expensing the amount so requred will help satisfy the matching principle, as each years sales is carrying a charge for the likely bad debts from those sales.

Which departments want the Bad Debt reserve kept as low as possible and which want the reserve to be kept as high as allowable?

The marketing department will want to make it lower and the finance department will want to make it higher.

Why do these departments feel their opinion about the reserve is the best way?

Marketing department would be optimistic and would expect to collect more. So, it will recommend a lower amount.

On the other hand, the finance would like to be conservative and would recommend a higher amount.