Provision, or allowance for bad debt is an accounting method where provisions are made for doubtful debt (debt that is unlikely to be recuperated) in preparation for it becoming bad debt (debt that it is confirmed as unrecoverable).
There are two accounting approaches to managing bad debt. The first is that, once doubtful debt becomes bad debt, it is charged directly to the income statement and accounted for at that point. This is also known as the direct write off method. The second approach involves providing for this debt in advance to account for the financial impact before it occurs. This is called the allowance method and is where organisations usually create a doubtful debt reserve of funds.
This reserve acts as a contra (or opposing) account within an organisation’s asset balance sheet. This means it is offset against the organisation’s assets in advance of the doubtful debt becoming bad debt. So the money in the contra account, or doubtful debt reserve, is ring-fenced and, if the doubtful debt becomes bad debt, it is subtracted from the organisation’s assets without disrupting the company’s balance sheet.
Following the financial crisis, this focus on provision for bad debt created a more balanced lending environment and reduced risk within the banking industry. But as the economy improves, there has been an additional benefit to this approach. In cases where doubtful debt has failed to translate into bad debt, this has created an excess of funds and leading to improved balance sheets and financial performance.
A recent example of this was seen in the third quarter results from Royal Bank of Scotland (RBS). In September, the bank announced it was erasing £800 million of bad debt provision due to significant improvements in struggling areas of its business, particularly in the bank’s Irish operations , Ulster Bank. Rising house prices in Ireland – a significant part of Ulster Bank’s business – contributed to this forecast. Indeed, house prices in Dublin saw a 23% rise in 2014 . This is a turnaround from RBS’s initial outlook at the beginning of the year, when it had anticipated losing £4.5 billion for settlement of bad loans in 2013 .
Another mechanism that became increasingly important to British banks after the financial crisis was the creation of ‘bad banks’. This is where a smaller bank is created within a bank, to contain and manage troubled loans and prevent them from compromising the rest of a bank’s operations – resulting in greater protection both for banks and investors.
In 2013, RBS transferred £38.3 billion of its highest risk doubtful debt loans into its bad bank, RBS Capital Resolution (RCR) , in order to segregate and sell off these troubled loans. So far, the results have been positive. Ross McEwan, Chief Executive Officer at RBS, said: “Setting up RCR was one of the best things we did”. The bank also outlined its expectation to “significantly outperform its previous guidance of around £1bn total impairments for full-year 2014 ”.
The recent focus on provision for bad debt fostered a safer lending environment. And as the economy continues to improve, organisations are positioned to reap the benefit of this prudent approach.
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