Allowance For Bad Debt

Also, called the "allowance for doubtful accounts", which is a bit more of a positive take on a gloomy topic. Banks record their estimates on loans they predict will go into default and not be repaid using the allowance for bad debt account.

Accountants must have balanced balance sheets (or they wouldn't be called balance sheets). The allowance for bad debt is a category accountants use to balance their sheets. Say a bank loans out $10,000 and estimates that 5% of the loans will go into default. The bank's accountants will enter $500 under the category of "bad debt expense" as a debit in accounts receivables, and $500 credit as an allowance for bad debt. So, basically, the allowance for bad debt is a way to offset the bad debt estimate. It's like a reserve in case a customer doesn't pay up.

Here's how it works if a customer actually doesn't pay up: Say in our example, a customer defaults on $100. This will be recorded as a $100 credit in accounts receivable to lower this amount, and as a $100 debit in the allowance for bad debt account. Seems a little counterintuitive, but it works.