What Is Bad Debt Provision in Accounting?

This can involve an additional charge to the bad debt expense account (if the provision appears to initially be too low) or a reduction in the expense (if the provision appears to be too high). If the value of debtors decrease, the level of doubtful debts also decrease. This implies that, the current provision for doubtful debts computed is less than that of the previous period. If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400. The sales method applies a flat percentage to the total dollar amount of sales for the period.

At the end of each financial year, most businesses that offer credit to their customers have significant amounts owed to them by their debtors. Leaving out your mortgage allows you to measure only the amount of consumer debt you’re carrying. Carrying high amounts of consumer debt, like credit cards, personal loans, auto loans, and medical bills causes more financial problems if you fall behind. On the other hand, if you want a total picture of your debt, include all your debt including your mortgage. These are signs that you’re spending too much of your income on debt payments.

• The important point here is that the customers within one group should have the same or similar loss patterns.
• Instead, it must be charged against the profit and loss account for 2014.
• Ask a question about your financial situation providing as much detail as possible.
• In other words, bad debt is a form of borrowing that doesn’t help your bottom line.
• Having a high level of loans that don’t bring in a return on investment, also called non-performing assets (NPAs), reflects poorly on a company’s financial health and can turn away potential customers and investors.
• For these three types of financial assets, you can apply either simplified approach or general approach.

The rationale of providing for bad debt is because we doubt a certain percentage of the sundry (total) debtors may fail to pay. Doubtful debts is not an operating expense for it does not involve any actual cash out flow. The term “bad debt provision” refers to creating circular flow of money an asset account that reflects credit balance, which, coupled with the accounts receivable, captures the net realizable value of the company’s debtors. Bad debt provisions are also known as an allowance for doubtful accounts, bad debts, or uncollectible accounts.

Importance of Bad Debt Expense

Bad debts refer to the trade receivables extended to the customers who are now highly unlikely to pay them back, i.e. these arrears seem uncollectable. Making this entry during a similar period when the company bills the client will ensure that all necessary expenses and earnings match accordingly. Eventually, once it is known that a certain client will not pay the bill, remove it from the provision for doubtful debts. Consider a retailer, UK Ltd., that has sold products worth £10,000 to a customer, PZ, on credit.

Specific provision is made when there is sufficient evidence that may make to believe that a number of receivables may not pay their money. In this case, individual receivable account are critically scrutinized to appraise the trade receivable on individual basis. Provision for doubtful debts should be included on your company’s balance sheet to give a comprehensive overview of the financial state of your business.

How to Calculate Bad Debt Reserve

In order to record the bad debt expense, the firm needs to pass an accounting entry to reflect the loss. The bad debt entry involves a debit to the bad debt expense account and a credit to the contra-asset account called the ‘bad debt provisions account’ or allowance for doubtful accounts’. The argument behind provision for bad debt is that at the end of the financial period, some of the debtors may not be able to pay. So, if this is the case, when they default, the organization will not be in a position to capture such an eventuality hence it will not reflect in the books of accounts. Therefore, the entrepreneur need to create a provision to safeguard his financial reports.

The provision for bad debts could refer to the balance sheet account also known as the Allowance for Bad Debts, Allowance for Doubtful Accounts, or Allowance for Uncollectible Accounts. If so, the account Provision for Bad Debts is a contra asset account (an asset account with a credit balance). It is used along with the account Accounts Receivable in order for the balance sheet to report the net realizable value of the company’s accounts receivable. The entry to increase the credit balance in these contra accounts is a debit to the income statement account Bad Debts Expense. The second is the matching principle, which requires that expenses be matched to related revenues in the same accounting period they are generated. Bad debt expense must be estimated using the allowance method in the same period and appears on the income statement under the sales and general administrative expense section.

How to calculate the provision for bad and doubtful debts

Or, they can provide advisory services and charge fees for that – thus they can have typical trade receivables. Banks usually provide lots of loans and under IFRS 9, they have to apply general models to calculate impairment loss for loans. For these three types of financial assets, you can apply either simplified approach or general approach.

Methods of Estimating Bad Debt

Under this accounting treatment, $5,420 would be written off as bad debt, and provisions for bad debts would increase from $5,600 to $7,000. From experience, all managers know that not every amount shown in the balance sheet as trade receivables (or debtors) will be recovered in the next financial period. Bad debt provision is important in times of crisis because it provides a financial buffer and protects businesses from being impacted too heavily by customers’ hardships. Bad debt is an inherent risk for many industries, so they must factor in the provisions for bad debt while preparing their financial budget. There are instances where companies assume that a certain percentage of their sales would become doubtful debt and subtract that amount from their revenue.

From past experience with the existing debtors, the management sets a percentage of the debtors to be profiled as doubtful. In this case, the percentage to be used will either be high or low depending on the level of doubts as to whether the debtors will pay or not. The entrepreneur/learner need to note that provision for doubtful debt is an additional deduction after bad debts have been subtracted from the gross debtor amount. In the online course Financial Accounting, it’s explained that one strategy is to overestimate bad debt provision. This is a more conservative provision strategy and can be helpful in times of unexpected crisis.

Examples of Bad Debt Provision

If your company’s bad debt exceeds the original estimate, you’ll be required to list it as a bad debt expense on your income statement. By making a more conservative provision, your company can avoid having to pay those expenses. Bad debt is a reality for businesses that provide credit to customers, such as banks and insurance companies. Planning for this possibility by estimating the amount of uncollectible loans is called bad debt provision and can enable companies to measure, communicate, and prepare for financial losses. Let us take the example of ABC Inc. to illustrate the process of creating bad debt provisioning. In the year, 2015the company decided to develop a provision for bad debts at 10% of the current accounts receivable, which stood at $ 500,000.