Updated July 3, 2023
What is a Bad Debt Provision?
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.
The term “bad debt provision” refers to creating 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.
Explanation
The underlying principle for bad debt provisions is that it is practically impossible to ascertain what amount of receivables the business will be able to recover during a year. As such, companies build some provisions based on historical trends and continuously re-adjust the net realizable value of the current accounts receivable. These adjustments are made to cushion the blow of irrecoverable receivables on the lending companies’ financials. Given that these adjustments understate the company’s reported profits, one should diligently record the reasons for the bad debt provisioning.
How to Determine Bad Debt Provision?
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. Typically, companies estimate the amount of bad debt based on the historical trend.
Under the allowance method, the estimated portion of the receivable is expensed from the income statement, and the same amount is credited to the provision for doubtful debts account that appears under the accounts receivable in the balance sheet.
Examples of Bad Debt Provision
Different examples are mentioned below:
Example #1
Let us take the example of a company that recognized credit sales worth $20 million during the year. Historical trends suggest that approximately 5% of the receivables turn bad. Next, determine the bad debt provision to make for the year.
Based on the given information, making bad debt provisions of $1 million (= 5% * $20 million) for the year is justified.
Example #2
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. In the following two years, the accounts receivable increased to $850,000 and then declined to $650,000. Therefore, prepare the journal entries for the bad debt provision of the three years, i.e., 2015, 2016, and 2017.
In the year 2015, the entire debt provision is created for $50,000 (= 10% * $500,000), and the journal entry for provisions of bad debt is as shown below:
|
Particulars |
Debit |
Credit |
| Profit & loss A/C | $50,000 | |
| Bad debt provision A/C | $50,000 |
In the year 2016, the accounts receivables increased by $350,000 (= $850,00 – $500,00) and bad debt provisions will be at 10%, so the incremental bad debt provisions is $35,000 (= 10% * $350,000). The journal entry is as shown below:
|
Particulars |
Debit |
Credit |
| Profit & loss A/C | $35,000 | |
| Bad debt provision A/C | $35,000 |
In the year 2017, the accounts receivables decreased by $200,000 (= $650,00 – $850,00) and bad debt provision will be at 10%, so the bad debt provision will be reduced by is $20,000 (= 10% * $200,000). The journal entry is as shown below:
|
Particulars |
Debit |
Credit |
| Bad debt provision A/C | $20,000 | |
| Profit & loss A/C | $20,000 |
Bad Debt Provision in the balance sheet
The provision for bad debts creates a contra account (an asset account with a credit balance), which is then listed in the balance sheet and placed just below the accounts receivable. The net realizable value of the outstanding accounts receivable by deducting bad debt provisions from the gross accounts receivable.
Reason for Bad Debt Provision
Some of the significant reasons are as follows:
- If the debtor’s financial position is likely to deteriorate significantly, the debtor defaults on its payment. The inability of the debtors to pay the obligations results in the receivables becoming bad debt.
- The receivables are recognized as bad debt when the creditors cannot recover for various reasons, including disputes due to price, quality, etc.
Journal Entry for Bad Debt Provision
When creating an inadequate debt provision, the amount is debited to the profit and loss account, and the same amount is credited to the wrong debt provision account. The journal entry looks like this:
|
Particulars |
Debit |
Credit |
| Profit & loss A/C | XX | |
| Bad debt provision A/C | XX |
Benefits
Some of the significant benefits are as follows:
- It facilitates anticipation of bad debts such that companies can prepare themselves accordingly.
- Helps present an accurate and fair picture of the company’s financials.
- It follows the matching principle as well as the accrual system of accounting.
- It is by the prudence or conservatism principle wherein any likely expense is booked immediately.
Disadvantages
Some of the major disadvantages are as follows:
- It is based on subjective estimates, and any significant error in calculation can result in underestimation or overestimation of the profit.
- It results in extra work since estimating bad debt expenses is continuous.
Conclusion
So, it can be seen that bad debt provisions can substantially impact a company’s financials as it directly influences the profit in the income statement. Therefore, the estimation of bad debt must be prudent and resolute.
Recommended Articles
This is a guide to Bad Debt Provision. Here we also discuss the introduction, examples of bad debt provision, and its benefits and disadvantages. You may also have a look at the following articles to learn more –
