Final answer:
Banks and financial institutions also estimate loan defaults for risk management, an important consideration during economic downturns.
Step-by-step explanation:
The student's question concerns the accounting concept of allowance for bad debts, which is essentially an estimation made by companies to account for receivables that are expected to become uncollectible.
Smart Touch Learning has estimated this amount to be $1000. In their accounting records, this will be reflected as a target balance for the allowance for doubtful accounts at the end of the period, indicating the anticipated losses due to defaults.
Banks and financial institutions regularly engage in similar practices by projecting a percentage of loans that borrowers will not repay. This allowance is factored into their calculations and affects the bank’s balance sheet.
Risk management strategies such as these are crucial, especially during economic downturns, when the incidence of loan defaults may unexpectedly increase leading to a significant impact on the financial stability of the institution.
Finally, from a consumer perspective, it is often recommended as a rational decision for individuals to use savings to pay off debt because it may actually lead to a net gain.
However, psychological factors can impede this rational economic behavior, as losses to savings are often perceived as more significant than the benefits of reducing debt.