What is Provision for Doubtful Debts?

What is Provision for Doubtful Debts?

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Jaya
Jaya Sharma
Assistant Manager - Content
Updated on Mar 31, 2024 03:07 IST

When a business extends credit to its customers, there is always a risk that some customers will not fulfill their payment obligations due to financial difficulties or for other reasons. Since not all receivables will turn into cash, accounting principles require businesses to present a more accurate picture of what they genuinely expect to collect. This is where the provision for doubtful debts comes into play.

Provision for Doubtful Debts

 

Table of Contents

What is Provision for Doubtful Debts?

The provision of doubtful debts or allowance for doubtful accounts is an accounting practice. Businesses use this practice to account for receivables that may not be collected. This provision is an estimate of the amount of accounts receivable that a company does not expect receiving a payment for this. This allows businesses to anticipate and reflect these potential losses in their financial statements accurately.

Impact of Provision for Doubtful Debts on Different Financial Statements

Creation of the provision for doubtful debts affects financial statements in the following ways:

1. Impact on the Income Statement

  1. Bad Debt Expense: When a provision for doubtful debts is created or adjusted, it results in a bad debt expense being recorded on the income statement. This expense directly reduces the company's net income or profit for the period. It represents the cost associated with credit sales that are anticipated not to be collected due to customer defaults or inability to pay.
  2. Operating Expenses: The bad debt expense is considered an operating expense because it's directly related to the sales and credit practices of the business. Including this expense in the operating expenses provides a clearer picture of the operational costs and profitability from the company's core activities.

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2. Impact on the Balance Sheet

  1. Allowance for the Doubtful Accounts: On a balance sheet, provision for doubtful debts is shown as a contra-asset account under accounts receivable. This means it reduces the gross accounts receivable to reflect the net realizable value—the amount of receivables the company realistically expects to collect. This adjustment ensures that the assets on the balance sheet are not overstated.
  2. Net Realizable Value of Receivables: The net realizable value is the difference between the total accounts receivable and the allowance for doubtful accounts. By adjusting the accounts receivable for the estimated uncollectible amounts, the balance sheet presents a more accurate and conservative view of the company's financial position.
  3. Equity Impact: Since the bad debt expense reduces net income, it also affects the retained earnings component of shareholders' equity. Lower net income means less profit is retained in the business, which can impact the company's ability to distribute dividends, reinvest in operations, or pay down debt.

Estimation Methods of Provision for Doubtful Debt

Two common methods are Percentage of Sales Method and Aging of Accounts Receivable Method. Each method has its approach and is chosen based on the company's preference, industry standards, and historical data availability. Here's how each method works, with examples:

1. Percentage of Sales Method

This method estimates the provision for doubtful debts as a fixed percentage of the total credit sales during a period, based on past experience and expected future trends. This method focuses on income statement. It does not directly consider the existing balance of accounts receivable.

Example: Suppose a company has credit sales of $100,000 during the year. Based on historical data, the company estimates that 2% of its credit sales will be uncollectible. The bad debt expense for the year would be calculated as $100,000 x 2% = $2,000. This amount is recorded as a bad debt expense on the income statement and also added to the allowance for the doubtful accounts on balance sheet.

2. Aging of Accounts Receivable Method

This method involves categorizing accounts receivable based on how long they have been outstanding and then applying different percentages to each category to estimate the uncollectible amount. The percentages used are based on historical data, with the assumption that the longer a receivable is outstanding, the less likely it is to be collected.

Example: A company's accounts receivable aging schedule is as follows:

  • 0-30 days: $50,000
  • 31-60 days: $20,000
  • 61-90 days: $10,000
  • Over 90 days: $5,000

The company applies the following percentages to each category based on past experience:

  • 0-30 days: 1% estimated to be uncollectible
  • 31-60 days: 3% estimated to be uncollectible
  • 61-90 days: 5% estimated to be uncollectible
  • Over 90 days: 10% estimated to be uncollectible

The calculation for the provision would be:

  • 0-30 days: $50,000 x 1% = $500
  • 31-60 days: $20,000 x 3% = $600
  • 61-90 days: $10,000 x 5% = $500
  • Over 90 days: $5,000 x 10% = $500

Total provision for doubtful debts = $500 + $600 + $500 + $500 = $2,100

This total provision amount is then used to adjust the allowance for doubtful accounts on the balance sheet.

The choice between these methods depends on the company's business model, the nature of its receivables, and data availability. The Percentage of Sales Method is simpler and more straightforward, focusing on sales activity. In contrast, the Aging of Accounts Receivable Method provides a detailed analysis based on the actual aging of receivables.

FAQs

Can the provision for doubtful debts be reversed?

Yes, if a previously written-off debt is later collected, or if the provision initially created is found to be excessive, the amount can be reversed, resulting in a decrease in the bad debt expense and an increase in net income.

Is the provision for doubtful debts the same as writing off a debt?

No, the provision for doubtful debts is an estimated allowance for potential future losses, while writing off a debt is the actual removal of an uncollectible receivable from the accounts, recognizing it as a loss.

How often should a business review its provision for doubtful debts?

A business should review its provision for doubtful debts regularly, typically at the end of each accounting period, to adjust for changes in the creditworthiness of its customers and other factors that might affect the collectibility of receivables.

Are there tax implications for creating a provision for doubtful debts?

The tax implications for creating a provision for doubtful debts vary by jurisdiction. In some cases, provisions may not be deductible for tax purposes until the debt is actually written off.

About the Author
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Jaya Sharma
Assistant Manager - Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio