A bad debt provision is the expense a lender or seller records to recognize that some borrowers will not pay. The provision increases an allowance (a contra-asset) so that receivables or loans are shown closer to their expected collectible value.
In simple terms:
- Provision is the income-statement expense.
- Allowance / reserve is the balance-sheet account that accumulates provisions.
- Write-off is removing a specific exposure that has become uncollectible.
Core Mechanics
One stylized expected-loss framing used in credit risk is:
[ \text{Expected Loss} = PD \times LGD \times EAD ]
where:
- (PD) is probability of default,
- (LGD) is loss given default (how much is lost if default happens),
- (EAD) is exposure at default.
Accounting standards implement these ideas with different details, but the practical goal is the same: recognize losses before they become obvious rather than waiting until the borrower has fully defaulted.
Why It Matters (Economics And Policy Context)
A provisioning system affects more than accounting presentation:
- Bank resilience: earlier loss recognition reduces the chance that banks appear well capitalized until losses suddenly surface.
- Credit cycles: provisions often rise in recessions (when defaults rise and outlook worsens), which can tighten lending conditions further (procyclicality).
- Pricing and underwriting: persistent provisioning pressure pushes lenders to reprice risk or change credit standards.
Practical Example
If a firm has $1,000,000 in receivables and expects 2% to be uncollectible, it may record a $20,000 provision. That reduces profit by $20,000 and creates a $20,000 allowance so the net receivable is $980,000.