According to IFRS 15, revenue should be recognized when the
following criteria are met:
When all the risks and rewards associated with the product have been transferred from the seller to the buyer.
Control over the goods is transferred to the buyer.
The amount of revenue can be reasonably measured.
The collection of payment is assured.
The cost of revenue is reasonably measured.
Let’s focus on point number 4. There are two types of sales, net cash
sales and credit sales.
Cash sales are when you collect the payment for goods at the time
of supply whereas credit sales are when you have supplied the goods or made
them available to the customer but collect the payment in the future as per
agreement with the customer.
You’re advised to make credit sales when the collection of payment
is assured. This can be done by checking the financial position of the customer
as well as the customer’s reliability so that there are lesser chances of
Nevertheless, chances of fraud still exist. Hence the concept of
bad debts and doubtful debts arise.
A credit sale is recorded by crediting the sales account and debiting the accounts receivable account.
As the name suggests, a doubtful debt is an account receivable that is probably going to go unpaid. In simpler words, it is an account receivable that might become a bad debt at some point in the future.
As per the prudence concept of accounting, revenue shall only be
recognized when it is certain whereas an expense shall be booked when it is
probable (more likely than not).
Since the doubtful debt is of an uncertain amount and time, a
provision or contra account must be created as per IAS 37. This is called
provision of doubtful debt and is treated as an operating expense as per the
This amount is also deducted from the accounts receivable account since it isn’t certain anymore that the amount will be recovered.
A bad debt is an account receivable that clearly won’t be paying back the money. For example, when a customer goes bankrupt or secretly leaves the country in order to avoid the payment, it is evident that he won’t be clearing his debt.
Such loss is treated as an operating expense and is referred to as
a bad debt. When a bad debt expense is incurred, it is credited to the accounts
receivable account and debited to either the bad debt expense account or the
provision for doubtful debt account.
There are two methods of dealing with a bad debt expense:
In the direct write-off method, the bad debt expense is only
written off when it’s clearly obvious that the invoice would go unpaid. Until
then accounts receivable would be recorded at its actual amount assuming that
all of the invoices will be paid.
Hence, the profits and accounts receivable would be overstated for
all the years since there would be no treatment for the doubtful debt.
This method goes against the accrual system of accounting as well
as the matching principle. The entry for bad debt expense through this method
would be as follows:
Bad Debt Expense Dr
Accounts Receivable Cr
However, in the allowance method, bad debt expense is estimated at
year end by taking a percentage of the sales or accounts receivable for the
This way, the matching principle of accounting is followed showing
a true and fair view of the financial statements.
Since we have an estimate and not a particular invoice that would
be uncollectible in the future, we can’t credit the accounts receivable account
neither the accounts receivable subsidiary ledgers account.
In order to deal with this issue, an allowance or reserve account is
created called the provision for doubtful debt account.
It shows that some of the company’s receivables are uncollectible
without having to credit the company’s accounts receivable account.
Since it is a contra asset, it reduces the accounts receivable to its Net Realizable Value i.e. the amount company expects to receive.
The entry to record the estimated bad debt expense at the end of each year is as follows:
Bad Debt Expense Dr
Allowance for Doubtful Accounts Cr
When a customer account is finally written-off the following entry is made:
Even though the customer owes us money, we book an expense because an operating loss is expected at an uncertain time in the future.
The matching principle or the revenue recognition principle of accounting states that expenses should be recorded in the period they are incurred to generate the revenue for that particular period regardless of when the cash is transferred.
If the bad debt expense was recorded in the period it occurred it would not match the sales against which the account receivable has been defaulted thus violating the matching principle.
Similarly, the prudence concept or conservatism principle of accounting states that any probable loss or outflow of cash should be recorded as an expense immediately but revenue shall only be recognized when it is certain that the amount will be received.
If we don’t apply this to bad debt expense and report it on the income statement when bad debt actually occurs, this would distort the true and fair view of financial statements.
The direct write-off of bad debt would overstate profits for a short while but then it would later understate profits and overstate expenses.
In order to avoid this issue, the accounts receivable shall be checked at the end of each year and shall be recorded at its net realizable value.
This shall be done by calculating an estimate of doubtful debts at the end of each year i.e. payment against the invoices expected to be defaulted by customers in the future at some point.
This way we book the expense of any future bad debts in the period in which sales regarding it are made as per the accounting principles.
Accounting/treatment of bad debt expense:
The estimate calculated is recorded by creating a provision account on contra asset account. It is a contra account because it is made to reduce the accounts receivable to bring it down to its net realizable value.
Since the bad debt is going to be incurred at an uncertain time in the future, it shall be booked as a provision in the financial statements as per IAS 37.
This provision of doubtful debt is a contra asset and hence credit in nature as compared to the accounts receivable that are classified as assets and are debit in nature.
The journal entry is passed at the year-end by debiting profit and loss account (bad debt expense) and crediting provision for doubtful debt.
Profit and loss – Bad debt expense DR
Provision for doubtful debt CR
We write off the debt when it has finally occurred by reducing the contra asset account i.e. the provision for doubtful debt account by debiting it.
The provision account is reduced because the estimated expense has been recognized as its own and don’t need a reserve account. Similarly, the accounts receivable is reduced by crediting it. The entry that should be passed is shown below:
Profit for doubtful debt DR
Accounts receivable CR
This way the bad debt expense is not directly written off and the income statement is not affected at all. This entry only affects the balance sheet and reduces the accounts receivable to the amount of invoices that are certainly collectible.
Accounts receivable is the amount owed to us by the customers that have bought goods from us on credit i.e. the sale has been made but the payment has not been received yet. The accounting entry to record accounts receivables is:
Accounts receivable Dr
When such sales are made, many customers end up defaulting their payments, and this results in a loss for the company. This loss or expense is then written-off from the accounts receivable account.
There are two ways of doing so. The two methods for writing off
bad debts are referred to as:
Direct-write off method
In the direct write-off method, when after a few years of trying to recover the amount the invoice is declared as bad or uncollectible, it is directly written off or expensed out in the income statement by debiting bad debt expense and crediting accounts receivable.
The following journal entry is passed:
Bad debt expense Dr
Account receivable Cr
For example, Nate made sales of $9,000 to Serena on credit in 2017. After so many attempts of trying to recover the money by Nate in 2019, Serena filed for bankruptcy and was unable to pay back Nate. Since Nate could not collect the receivable from Serena, this $9,000 should be written off during 2019.
How is Nate supposed to go about this bad debt expense?
Nate should pass the following journal entry in his books to
write-off Serena from his accounts receivable:
Bad debt expense Dr 9,000
Accounts receivable Cr 9,000
$9,000 shall be reported as an operating expense in his income statement
for the year ended 2019 and accounts receivable on his balance sheet shall be
reduced by this amount.
At the end of every accounting period an estimate of doubtful
debts is measured. Doubtful debts are those invoices against which sales have
been made on credit but they are not expected to be turned into cash for
For example, one of your customers may have faced a huge loss or is maybe facing liquidity issues or may have huge loans to pay off.
Any such customers might not be able to pay back the debt due to deteriorating financial position.
Such debts are future losses and shall be expensed out immediately
as per the prudence concept also known as the conservatism principle.
Since it is unknown to the company what amount each customer would
default, the accounts receivable cannot be simply written-off. This is why a
contra account is created known as the provision for doubtful debts or
allowance for doubtful debts.
It is a credit account in nature because it is related to accounts
receivable (asset). The provision account reduces the value of accounts
receivable on the balance sheet to its net realizable value.
This means that the company reports the original amount the customers owe it as accounts receivable. Still, those accounts receivable that are not expected to be turned into cash are reported under the provision for doubtful debts.
of bad debt expense:
The bad debt expense is recorded by passing the journal entry:
Bad debt expense Dr xx
Provision for bad debt Cr xx
This provision, when actually turned into bad debt after several attempts of trying to recover the money is written-off from the accounts receivable account through the following journal entry:
Provision for bad debt Dr xx
Accounts Receivable Cr xx
ABC has a closing balance amounted to $20,000 in trade accounts receivable. At the start of the year, management decides to create a 2% provision for the bad debts.
At the end of year management decides to write off XYZ LTD debtor
account balance as bad debt. The debit balance of XYZ LTD account is $500.
A doubtful debt is an accounts receivable that is expected to be an uncollectible invoice where, an accounts receivable is the amount owed to you against the sales you made or services you provided on credit.
Since the sales are made on credit there are chances that some
customers might default their payments. This would be a loss for the entity.
Hence, in order to follow the prudence concept and matching
principle of accounting the bad debt expense is reported using the allowance
In this method an estimate of future losses is projected by
calculating a percentage of the accounts receivable or net sales for the year.
This percentage represents the amount of invoices that is expected
to be uncollectible or will be defaulted at some point in the future.
Now since this expense is probable, it should be reported on the financial statements as per the prudence concept in order to show the true and fair view.
Also, even though the bad debt expense will occur in the future,
it is related to the sales made this year. Meaning that it should be booked
this year rather than when the customer provides evidence of bankruptcy or
disappears without paying in the future.
To be able to deal with this issue a reserve account or contra account is created to record the doubtful debts.
This expense is shown on the income statement as per matching principle and reduces the accounts receivable on the balance sheet as per prudence concept. Let’s illustrate this with an example.
Cujewl Ltd. is a manufacturing company that manufactures
customized jewelry. Its total credit sales for the year ended 2013, 2014 and
2015 are $10,000,000, $15,000,000 and $20,000,000 respectively.
The amounts received in each year against credit sales are
$9,000,000, $12,000,000 and $13,000,000 for the years 2013, 2014 and 2015
Cujewl projects its doubtful debts at 1% of the net sales. In 2015, one of Cujewl’s customers, KAYBEE ltd. filed for bankruptcy.
KAYBEE owed $100,000 to Cujewl against purchases made in 2013 out of which it could only pay $60,000 (included in the amounts received). Prepare the following ledgers for 2013, 2014 and 2015:
Provision for doubtful debt
The bad debt of Kay-Bee of $40,000 was adjusted against the provision made in 2013 of $100,000 hence maintaining the matching principle.
Also, the accounts receivable was reduced respectively reporting
the amount that is expected to be received by the company. This method of
reporting bad debt expense is the most used method since it shows the true and
fair view of accounting.
ABC LTD Company is started its business on 1 Jan, 2018. They want
to record 1% as provision for debts which are due from more than 180 days.
Total Receivables at 31Dec, 2018 are $500,000.
And amount due to debtors aged more than 180 days are $300,000.
Make necessary journal entry to record the provision amount.
As the company policy to take 1% of receivables amount which is
due from more than 180 days instead of total trade debts. So we will calculate
the provision amount as
Direct write-off method is one of the two commonly known methods of treating the bad debt expense.
Through the direct write-off method, we straightforwardly book a bad debt expense by debiting the bad debt expense account and crediting the accounts receivable account.
Hence, the sales amount remains intact, account receivables are eliminated and the bad debt expense account increases.
For example, Ali made sales worth $2000 in 2018. The bad debt occurred in 2019 when the customer ran off without payment of the debt. What will be the treatment as per the direct write-off method?
A bad debt expense of $2,000 will be reported as operating expense in the income statement of Ali for the year ended 2019 and the accounts receivable balance would be reduced by $2,000. The following entry would be passed:
Bad debt expense DR $2000
Accounts receivable CR $2000
Allowance method is the second method of treating the bad debts expense and involves creating a provision or contra account.
An estimate is calculated as a percentage of accounts receivable or net sales or is based on the time period the invoices haven’t been paid for.
This estimate is the amount of expected uncollectible invoices and is reported as bad debt expense for the year.
It also reduces accounts receivable accordingly so that it is
reported at its net realizable value.
The direct write-off methods violate the matching principle of accounting which states that every expense booked for the year should match the revenue it has generated.
In the direct write-off method, bad debts are expensed out when
they occur and are not related to the sales for the year.
On the contrary, the allowance method allows you to book a provision for the doubtful debt at the end of each year.
Hence, the bad debt expense recorded each year is matched to the net sales for the year as per the matching principle of accounting.
The direct write-off method is an easier way of treating the bad debt expense since it only involves a single entry where bad debt expense is debited and accounts receivable is credited.
The allowance method is more complicated since it requires you to
create a provision account which is a contra-asset account.
This procedure might result in wrong accounting entries negatively affecting the true and fair view of the financial statements of the company.
As per the prudence concept of accounting which is also referred to as the conservatism principle, revenue shall only be recognized when certain and expense shall be booked when probable.
In the direct method of accounting, bad debt expense is booked when all attempts of recovery have been exhausted and there is no chance of receiving the money.
The accounts receivable is reduced by the bad debt expense and sales remain intact.
Conversely, provision for doubtful debt is booked as a bad debt
expense under the allowance method. A provision is a probable outflow of cash of
an uncertain amount or time.
This provision reduces the accounts receivable on the balance sheet since it is a contra asset. The allowance method shows a true and fair view of the financial statements since it follows the generally accepted accounting principles (GAAP).
Chances of error:
The allowance method involves calculation of an estimate which is based on significant judgment. If this estimate is miscalculated, it may lead to material errors distorting the true and financial view of financial statements.
This problem, however, does not occur in the direct write-off method since no calculation is involved and the bad debt is of a particular invoice.
Any company that has a policy of selling goods on credit has to deal with the problem of bad debts. Bad debts are uncollectible invoices that are written-off from the accounts receivable after all attempts of recovery have been made.
This loss of revenue is referred to as a bad debt expense.
As per the international accounting standards (IAS), any expense incurred shall be reported on the income statement of the entity.
An income statement is a financial statements that must be prepared at the end of each accounting period as per the IAS and reports the net income or loss earned by the company.
Now the question arises, how to report the bad debt expense? Should we just report it as an expense when the invoices are declared uncollectible? Is it that easy?
Unfortunately, this method of writing off bad debt violates the
generally accepted accounting principles and is not appropriate for reporting
financial statements with a true and fair view.
There are two methods of reporting bad debt expense; the direct write-off method that is explained above and the allowance or provision method.
Direct Written Off Method
This method is used by organizations to write off the bad debts arises from the credit sales that are directly written off as an expense to the income statement.
Generally, this method is used when accounts are prepared for taxation purposes.
Allowance/ Provision Method:
The allowance method requires you to create a bad debt provision against doubtful debts. Doubtful debts are invoices that are included in accounts receivable but are not expected to be turned into cash.
As per the generally accepted accounting principles (GAAP), these
expected uncollectible invoices shall be reported as an expense.
The prudence concept requires you to book an expense as soon as it
is probable (more likely than not) and recognize revenue only when certain.
This implies that the accounts receivable and the net profit would be overstated if no doubtful debts are written-off or expensed out.
How to calculate the doubtful debts?
The doubtful debts are projected based on the invoices that haven’t been paid for in a long time or are calculated as a percentage of sales or accounts receivable.
This estimate can’t be directly written off from the accounts
receivable account since no specific invoice can be proven bad in the present.
Hence a contra asset account is created since this amount is a
credit balance on accounts receivable (asset) and can’t be classified as a
This estimate is referred to as a provision because it is an expense that would occur in the future at an uncertain time. The journal entry to create provision is shown below:
Bad debt expense DR
Provision for bad debt CR
The provision for bad debt is estimated each year at the end of the accounting period. This way the matching principle of accounting is followed and no GAAP are violated.
The matching principle states that every entity must book its
expenses that relate to the revenue it has generated.
The provision for bad debt expenses out any future uncollectible invoice related to the accounts receivable booked this year no matter when the bad debt occurs.
This way only the balance sheet items are affected and there is no effect of bad debt expense on future income statements. The following entry is passed to write-off accounts receivable that defaulted their payments:
Provision for bad debt Dr
Accounts receivable Cr
The doubtful debts have decreased since they have gone bad hence a debit to provision for bad debt is recorded. Simultaneously, the accounts receivable is written-off by a credit to its account.