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 fraud.
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 prudence concept.
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:
- Direct write-off
- Allowance method
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 year.
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:
Allowance for Doubtful Accounts Dr
Accounts Receivable Cr