Provision for doubtful debts definition
/What is the Provision for Doubtful Debts?
The provision for doubtful debts is the estimated amount of bad debt that will arise from accounts receivable that have been issued but not yet collected. It is identical to the allowance for doubtful accounts. The provision is used under accrual basis accounting, so that an expense is recognized for probable bad debts as soon as invoices are issued to customers, rather than waiting several months to find out exactly which invoices turned out to be uncollectible. Thus, the net impact of the provision for doubtful debts is to accelerate the recognition of bad debts into earlier reporting periods.
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Accounting for the Provision for Doubtful Debts
A business typically estimates the amount of bad debt based on historical experience, and charges this amount to expense with a debit to the bad debt expense account (which appears in the income statement) and a credit to the provision for doubtful debts account (which appears in the balance sheet). The organization should make this entry in the same period when it bills a customer, so that revenues are matched with all applicable expenses (as per the matching principle).
Later, when a specific customer invoice is identified that is not going to be paid, eliminate it against the provision for doubtful debts. This can be done with a journal entry that debits the provision for doubtful debts and credits the accounts receivable account; this merely nets out two accounts within the balance sheet, and so has no impact on the income statement. If you are using accounting software, create a credit memo in the amount of the unpaid invoice, which creates the same journal entry for you.
It is highly unlikely that the provision for doubtful debts will always exactly match the amount of invoices that are actually unpaid, since it is only an estimate. Thus, you will need to adjust the balance in this account over time to bring it into closer alignment with the ongoing best estimate of bad debts. 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).
Example of the Provision for Doubtful Debts
A company has $100,000 in accounts receivable at the end of the fiscal year. Based on past experience and industry trends, management estimates that 3% of outstanding receivables may not be collected. To account for this, the company needs to create or adjust a provision for doubtful debts of $3,000 ($100,000 × 3%).
The associated journal entry is a $3,000 debit to bad debt expense and a $3,000 credit to the allowance for doubtful accounts. This entry records the expected loss as an expense and establishes a contra-asset account that reduces the net realizable value of accounts receivable. On the firm’s balance sheet, this results in an account receivable of $100,000, which is then reduced by a $3,000 allowance for doubtful debts, resulting in net accounts receivable of $97,000.
If a specific customer later defaults on a $1,000 invoice, the company would write off the receivable with a $1,000 debit to its allowance for doubtful debts and a $1,000 credit to its accounts receivable account. This write-off does not affect the income statement again, since the expense was already recognized through the provision.
Presentation of the Provision for Doubtful Debts
The provision for doubtful debts is an accounts receivable contra account, so it should always have a credit balance, and is listed in the balance sheet directly below the accounts receivable line item. The two line items can be combined for reporting purposes to arrive at a net receivables figure.
Terms Similar to the Provision for Doubtful Debts
The provision for doubtful debts is also known as the provision for bad debts and the allowance for doubtful accounts.