Christian Debt Recovery

What Is Debt Service Reserve Fund

May 3rd, 2009 |

Author: Gavin

what is debt service reserve fund

Receivables, Bad Debts and Reserves. Oh my!

What is an account receivable? What is the significance of this accounting transaction and what can affect the amount of the receivable recorded? To start, accounts receivable is one of a series of accounting transactions that deals with billing customers when money is owes to a company or organization for a service that was provided in the past to a customer. Typically the business will generate an invoice for the customer who must pay on that debt within a pre-determined time period. This established time period is called either a credit or the payment terms. So far the idea of accounts receivable appears to be simple. A good or service is provided with a credit to a customer who is then billed for those services rendered in the form of an invoice which is in turn paid within a payment term. The credit is matched to the expenses of the company or organization in order to balance out the entities financial statements; accounting for all of the funds passed in the transaction. But, there are factors that would cause the amount recorded in the accounts receivable to differ from the original net realizable value. To clarify the net realizable value is the amount that originally was expected to be paid by the customers in order to settle their obligation. One such factor that would change this recorded amount would be the bad debt expense.

A bad debt expense, also referred to as an uncollectible accounts expense, represent the accounts receivable that are not expected to be collected. This estimated expense is recognized in the fiscal period of the sale by the company whenever it permits the customer to purchase a good or service with credit. Companies and organizations understand that when a good or service is purchased with credit there is a probability that the customer will not pay on that good or service in the future as agreed upon in the payment terms. Some bad debt losses are inevitable. Individual companies or organizations face the idea of bad debt losses in completely different ways. One entity when making a credit sale will place internal control policies and procedures to make sure that the loss is as minimal as possible. Doing so guarantees that every effort to collect the lost debt is made to collect the amount owed. On the opposite side of the spectrum a different entity would openly accept high risk customers knowing ahead of time that there is a chance they will experience a lot of debt loss. This may seem hazardous to the company or the organization in the long run. But, to maximize the return of investment, the entity will have the customer place a down payment on the service or good that is almost equal to the cost of that item. The company may choose to take on this extra risk in the second example to ensure a higher sales volume. The credit standards are not as tough which opens up a larger customer base. This is what a company considers when deciding how it wants to approach the possibility of bad debt loss. But how is a bad debt expense recorded within accounts receivable?

If an account receivable is determined to be a bad debt expense, or uncollectable, to reduce the carrying value of the asset a value adjustment will be recorded to minimize the impact of the bad debt loss. Speaking strictly in bookkeeping language the account that allows for bad debts is called a contra asset because, when reported, it subtracts from the asset amount of the balance sheet. To give an example; if one-thousand dollars was owed on an accounts receivable that was estimated to be a bad debt loss it would be recorded as a one-thousand under assets on the company balance sheet. The company’s contra asset account allows them to reduce that bad debt by a certain amount. For this example let us say that the allocated amount is two-hundred dollars for bad debts. This would reduce the amount recorded under accounts receivable from one-thousand down to eight-hundred dollars. The adjustment communicates to the readers that there is an estimated portion of the total amount is expected to become uncollectable. The work on balancing the accounts does not stop there. The problem with the approach is that the account receivable is only estimated it does not guarantee which specific accounts that will be determined as uncollectable. So the company or organization must identify the specific accounts throughout the year that need to be a write-off. When the specific accounts are identified as a write-off it will be recorded as a debit to the Allowance for Bad Debts and a credit to the Accounts Receivable. Once the specific account is acknowledged it should not affect the net amount on the balance sheet because in the bad debt expense was already offset by the asset and the contra asset accounts. To bring this full circle take the previous example of one-thousand Accounts Receivable and the two-hundred Contra Asset account. If fifty dollars was determined as a write of you would subtract that amount from both the Accounts Receivable and Contra Asset (Allowance for Bad Debts) portion of the financial statement. The results are having nine-hundred fifty dollars in the Accounts Receivable and one-hundred fifty dollars in the Contra Asset account. Reducing the Accounts Receivable amount by the Contra Asset amount it still results in the net amount of eight-hundred dollars, the same net amount as the estimate. If you are still confused please see the outline below.

Presentation of the Allowance for Bad Debts

Accounts receivable………………………………………. $1000

Less Allowance for bad debts………………………… $200__

Net accounts receivable……………………………….. $800

Presentation after the fifty dollar write-off

Accounts receivable……………………………………… $950

Less: Allowance for bad debts………………………. $150__

Net accounts receivable………………………………. $800

Where can this practice been seen working in the economy? Take a look at the Mortgage industry and the loan loss reserves. When a company decides to process a loan to a customer the entity has already set aside a reserve against the bank’s total loans in the event that it becomes uncollectable. It works the same way as outlined above. When a loan is determined as uncollectable is it removed from the portfolio and its value is deducted from the reserve account. As outlined above this still does not affect the net accounts receivable because the loss had already been accounted for. The loan loss reserve in theory, like the Allowance for Bad Debts, ensures that the bank will make every reasonable effort to collect all amounts that are due. This is just one example on how the mechanic is supposed to work in practice. To get a better understanding try to seek out other examples on when the accounts receivable would need to be edited for a bad debt expense. Through practice the allocation of funds will make sense and it will become easier to build up to more complicated recordings in the future.

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