ALLOWANCE FOR doubtful DEBTs
Financial Statements are prepared to present a true and fair view of affairs of a business. The amounts of Asset, Liabilities and Capital presented in the Financial Statements shall be as accurate as possible.
It is common in the business that all the receivable balances in books of account may not be completely realized (received cash from) as some debtors may default in the future. This may happen despite having any indication of their default on the balance sheet date.
Receivable classified as Bad debt usually had existed in the books of account and had not been recovered from previous accounting periods. There may have arisen a few reasons/ indications which made it certain that these receivable amounts may not be recovered.
However, as the the future is always uncertain and there may be the debtors which may not have any reason to be classified as unrecoverable at the balance sheet date but may become bad in the future. The amount of these debts are classified as doubtful debt (not bad debt), because at the balance sheet date there are doubts that these amounts may go bad in the future, but we do not have the certain reasons to classify it as BAD debt, therefore instead of writing off we may create an allowance that these amounts may become irrecoverable in the future. .
Prudence concept requires that this possibility of current receivable of becoming bad debt in the future shall be reflected/ provisioned in the balance sheet. If this allowance is not made, the amounts of receivable in Balance sheet and profit in P&L shown, may not be completely accurate.
The amount of this Allowance for doubtful debt can be estimated based on previous experience of a business or practice of the industry in which the business operates.
Types of allowances for doubtful debt
The Allowance of doubtful debt may have two types, General and Specific Allowance.
General Allowance: –
Based on the experience a specific amount from (or percentage of total receivables) is assumed to be not recoverable in the future and an allowance of this amount is made.
Specific allowance: –
When there are reasonable indications but not certainty, that a specific debtor may not be able to pay in the future against credit sales made to it, a specific Allowance against that debtor is made at the balance sheet date. This is done by reviewing each debtor at the end of the accounting period for the possibility of that debtor going bad in the future.
Indications of Debtor going bad
Although it is very hard to predict if any debtor may become unrecoverable in the future. But there are few circumstances which may indicate a future possible default by a customer/ debtor:-
a. Aging Analysis- The longer the debtor has not paid, more chances are there that the customer is not going to pay and receivable from the debtor is irrecoverable.
b. Financial Health and liquidity of the Company- Financial Statement of the company are analyzed to review its financial health. Further it is reviewed if the company has enough liquid assets to repay its short term liabilities. However, if these analyses are indicative of any financial difficulties and liquidity issues then the allowance against that customer shall be considered.
c. Litigation against the Debtor: If there is any major legal suit or litigation is in process against the debtor, especially requiring closure of the business OR demanding considerable amount for payment, this may be an indication that the debtor may face financial difficulty if the case would be concluded against the customer/ debtor.
d. Change in Management: Change in management or ownership in the customer may be an indication of business disruption at customer and shall be considered if this may result in the future default by the customer and to make allowance against the customer.
In practice most businesses do not go into that much detail to review each customer and only make general allowance based on the total amount of the receivable at the end of an accounting period.
Accounting for Allowance for Doubtful Debt
Accounting Entries for Initial Allowance of Doubtful Debt
Dr. Bad Debt Expense XXX
Cr. Allowance/ Provision of Doubtful Debts XXX
allowance for doubtful debt is made to record the losses due to the probability that the debtor may not pay in the future. However, at the time of making this provision, the amount and from which debtor amounts will not be recovered, cannot be established with certainty.
Therefore, the estimated amount is expense out as Bad Debt Expense, whereas an allowance for bad debt is created and recorded in allowance for doubtful debt accounts instead of reducing the balances of any particular debtor. Therefore this is also sometimes called Allowance for doubtful debts.
The amount estimated as allowance for doubtful debt at the period end is assumed as an amount which may not be recovered in the future from the debtors. This amount shall be the closing balance of the ledger for allowance for doubtful debt which is a real account and its closing balance will be carried forward as the opening balance for next year.
Bad debt against Specific provision
If any debtor is declared as bad debt against which the specific provision have already been made accounting entry will be as follows:
Dr. Allowance for doubtful Debt XXX
Cr. Debtor Account XXX
As the provision against this debtor going bad has already been made and loss had been recorded there is no need to record bad debt expense again. Instead, the provision already made for this bad debt is reversed (as provision made earlier by recording a credit entry, now a debit entry is recorded to reverse this provision) and the amount is declared bad debt and written off decreased the receivable ledger account (receivable account is credited).
Accounting Entries for Subsequent Provision of Doubtful Debt.
The estimated amount of allowance for doubtful debt is the amount considered not recoverable in the future from the debtors. This estimated amount shall be the closing balance of the ledger for allowance for doubtful debt.
The closing balance of the allowance for doubtful debt ledger is carried forward as opening balance. Further the debtors against which specific provision have already been made declared and written off during the period are revered from this year’s provision account. To reach out at the provision for the current year as closing balance of Provision T- Account, Only the difference between last year provision is charged as expense and increase/ decrease in the allowance for doubtful debt,
Accounting Entry of allowance for doubtful debt
Dr. Bad debt Expense XXX
Cr. allowance for doubtful Debt (Difference amount only) XXX
Where difference amount to be credited= Estimated amount of doubtful for current year – Bad debt written off- opening balance of provision ledger.
It is understandable that this accounting treatment is confusing. Below provided illustration shall elaborate the accounting treatment for allowance for doubtful debts.
- Example
For example at the year end ABC Company had the receivable for the amount of $ 50,000. It was decided that 5% of the total receivables may not pay in the future therefore a general provision needed to be made. Further there was a lawsuit against Mr. Champ, a debtor proceeding in the court of law.
The receivable balance against this debtor stood at $ 800. So the accounting entry for this year would be as follows (assuming there is no opening balance for allowance for doubtful debt accounts carried forward from previous years):
Dr. Bad debt Expense ($50,000 X 5%=2,500+800) $ 3,300
Cr. allowance for doubtful Debt $ 3,300
This bad debt expense of $ 3,300 is charged in profit and loss for the year and balance in the Provision account will be carried forward as opening balance for the next year for the allowance for doubtful and.
Now in the following year assume a debtor with the balance of $ 800 against Mr. Champ became irrevocable and written off as bad debt. We further assume that there were few indications at the last year end that this Following entry will be recorded;
Dr. allowance for doubtful debt $800
Cr. Mr. Champ (Debtor) $800
Increase in Provision
At the end of the following year the closing receivable balance stood at $60,000 and it was decided that 10% of the total receivable may not pay in the future. The calculation for the difference to be recorded will be as follows;
Amounts in $
Estimated doubtful debt this year ($60,000 X 10%) 6,000
Less: Opening balance of provision account (3,300)
Less: Bad debt during the period (800)
Difference to be recorded this year 3,500
So the accounting entry to be recorded this year will be;
Dr. Bad Debt Expense $ 3,500
Cr. allowance for doubtful debt $3,500
Decrease in Provision
Assume that at the end of further next year the debtor balance was $55,000 and it was decided that only 3% debtor will not be able to pay in the coming year so the estimated amount of doubtful debts will be ($5,500 X 3%) $1,650 and the difference shall be calculated as given below;
Amounts in $
Estimated doubtful debt this year ($5,500 X 3%) 1,650
Less: Opening balance of provision account (6,500)
Difference to be recorded this year (4,850)
As the value of total doubtful debt is lower than previous periods this means closing balance for this year’s provision account will be lower than last year and we shall record the gain instead of bad debt expense. This will result in reversal of expense and provision booked in previous periods.
Difference between Bad Debt and allowance for doubtful debtgers
For the students and beginners to accountancy, it becomes confusing to differentiate between Bad Debts and allowance for doubtful debt and how both are related to each other.
| Bad Debt | allowance for doubtful debt | |
| Definition | When it is certain that debtor will not pay the amount receivable from him | As the name suggest, it is doubtful, weather the debtor will pay in the future or not as there are some indications but not certainty about its default |
| Nature of Loss | Actual loss | Estimated loss |
| Effect of Balance sheet | Require writing off the amounts receivable from debtor Account | Instead of writing off receivable a contra account by the name of allowance for doubtful debt is created. |
| Effect on Income statement(same for the both) | While crediting the debtor account for writing it off, an expense by the name of Bad Debt expense is booked. | While crediting the provision/ allowance account for writing it off, an expense by the name of Bad Debt expense is booked. |
| Calculation and accounting treatment. | The total amount considered as irrecoverable is expense out | The estimated amount is the allowance for the current period, so only the difference between Opening balance plus any bad debt booked during the year and this year allowance is charged to the profit and loss account. |
