Normally accounts receivable are recovered over the credit period allowed extended to recover. But certain receivables are not recoverable due to a variety of reasons that differ from business to business and individual and other circumstances of the debtors. A business, on the basis of its experience over a period, is normally in a position to make an estimate about accounts receivable, which according to its management, will remain unrecoverable. The amount is normally expressed as a percentage of total ARs. While finalizing the accounts for the fiscal period, the businessman makes an allowance for such unrecoverable debts, which according to him, may be difficult to recover. This allowance for bad debts does not represent actual bad debts. This is a provision to meet bad debts expenses that may occur in the future.
On the other hand, bad debts expenses represent the actual amounts of debts that could not be collected for a variety of reasons. Bad debt expenses are charged to the bad allowance accounts at the end of the accounting period. The bad allowance accounts are further revised by making a further provision against the profits of the organization, so the balance in the bad debts allowance accounts comes to the required level as estimated by the entrepreneur. As already stated, allowance for bad debts is normally a low (one or two) percentage of ARs. The accounting department of an organization determines the level of allowance required in order to cover up actual bad debts expenditure in the future. Such estimates are made on a yearly basis.