Bad Debt Reserves
Banks are staging a turnaround on improving loan performance, but that doesn’t mean they’re in the clear. Look out for stale profit margins as bad debt reserves grow to cover additional losses.
Renewed Focus on Bad Debt Reserves
Accounting for lending firms is already tricky business, but lenders have a recent concern that hasn’t been this big since the Great Depression—bad loans. With borrowers out of work, mortgages resetting at record rates, and divebombing real estate prices, banks will have to stockpile more cash in their bad debt reserves in order to protect from future declines. While safety is never a bad thing, especially in this economic climate, money set aside for safekeeping earns an abysmal return.
Understanding Accounting
Also known as a doubtful debt reserve, the bad debt reserve is posted in the accounts receivable and is written off as the uncollected debt rises to the surface. A bad debt reserve is listed as an asset, since it has yet to be used, but because it has to sit in the business and isn’t invested, the returns generated on bad debt reserves are generally far lower than the company’s average return on equity. That isn’t such a good thing, as companies want to leverage up their free cash and assets as much as possible.
How Companies Figure a Bad Debt Reserve
Knowing how much to keep in your doubtful debt reserve is not a perfect science. Well, it would be if you could predict the future. Most companies take a very simple approach, usually one of the following:
1) Set aside a percentage of sales, say .3% to covering accounts receivables that won’t be collected.
2) Set aside a percentage of sales on accounts that have already drawn concern
3) Modify total amounts set aside by creditworthiness, adding and subtracting funds per account based on criteria like payment schedules, high-debt customers, or overleveraged buyers.
