Although businesses that owe you money may have an obligation to pay you, that doesn’t mean there’s any certainty that they will. For a wide range of reasons, from insolvency to cash flow problems, payment may not be forthcoming. That’s something that your business needs to account for on the balance sheet. How do you do that? You create a provision for doubtful debts. Learn more about this accounting technique, including how to calculate the provision for bad and doubtful debts, right here.
Provision for bad debts meaning
The provision for doubtful debts, which is also referred to as the provision for bad debts or the provision for losses on accounts receivable, is an estimation of the amount of doubtful debt that will need to be written off during a given period. Put simply, it’s a provision – or allowance – for debts that are considered to be doubtful.
There are two types of bad debts – specific allowance and general allowance. Specific allowance refers to specific receivables that you know are facing financial problems, and so may be unable to pay off the debt. General allowance refers to a general percentage of debts that may need to be written off based on your business’s past experience.
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. Otherwise, your business may have an inaccurate picture of the amount of working capital that is available to it.
How to calculate the provision for bad and doubtful debts
Typically, businesses estimate their amount of bad debt based on historical experience. When entering the provision for bad debts into the general ledger, there’ll be two ledger accounts:
the provision for doubtful debt
the provision for doubtful debt – adjustment
The provision for doubtful debt shows the total allowance for accounts receivable that can be written off, while the adjustment account records any changes that are made for this allowance. When you need to create or increase a provision for doubtful debt, you do it on the ‘credit’ side of the account. However, when you need to decrease or remove the allowance, you do it on the ‘debit’ side.
When you encounter an invoice that has no chance of being paid, you’ll need to eliminate it against the provision for doubtful debts. You can do this via a journal entry that debits the provision for bad debts and credits the accounts receivable account.
Provision for bad debts example
To give you a clearer picture of how provision for losses on accounts receivable works, here’s an example. Imagine Company A has a total of £100,000 account receivables at the end of the year. Company A decides to create a provision for doubtful debts that will be 2% of the total receivables balance. So, you can calculate the provision for bad debts as follows:
100000 x 2% = £2,000
You’d enter this in your business’s accounting journal like so:
|Provision for doubtful debts - adjustment||2,000||X|
|Provision for doubtful debst||2,000||X|
However, by the end of the next year, Company A’s total accounts receivable comes out to £150,000. This means that the provision for doubtful debts needs to be increased. So, this means that the provision for doubtful debts should be adjusted to £3,000 (150000 x 2% = £3,000). In your records, the adjusted allowance will look like this:
|Provision for doubtful debts - adjustment||3,000||X|
|Provision for doubtful debts||3,000||X|
So, what happens when you need to increase the provision for losses on accounts receivable. For example, imagine Company A’s accounts receivable total has fallen to £125,000 by the end of the next year. This means that you need to adjust the provision for bad debts once again. The journal entry for this adjustment will look like this:
|Providion for doubtful debts - adjustment||2,500||X|
|Provision for doubtful debts||2,500||X|
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