The main purpose of a business entity is to earn a profit, and the international accounting standards require every business entity to report its financial gains and losses. Most small businesses are relying on the operating cash inflow for their day-to-day operations. Therefore, more sales mean more cash inflow. But it is also true that all the sales do not bring instant cash inflow. The sales of a business are a combination of cash sales and credit sales.
Every credit sale results in a debtor account in the assets of the business. The seller agrees to allow the buyer to make payment at a future date. Unfortunately, all the debtors do not honor the future payment terms and result in bad debt. But a company can only record bad debts when it is certain that payment cannot be recovered.
According to the matching principle of accounting, expenses related to certain revenues should be recorded in the same period when they occur. Therefore, a business needs to estimate bad debts that can occur during a financial period.
But how can the company get an estimate of the probable amount of bad debts in an accounting period?
Reserve or allowance for doubtful debts is created in the company’s accounts to ascertain the estimated bad debts.
What Is Allowance For Doubtful Debts?
Allowance for doubtful debts can be defined as,
‘It is a contra-asset account created in a business’s accounts against the debtor accounts or account receivables. The allowance for doubtful debts is recorded in the balance sheet as a deduction from the total debtors/account receivables. A journal entry is also passed in books of accounts by crediting debtors and debiting allowance for doubtful debts.’
Understanding Doubtful Debts Reserve
Every company or business entity has outlined its collection policy and receivables recovery procedures. Despite the transparency of the policy and procedures, the risk of bad debts is always there. There might be unprecedented circumstances going on with the debtor resulting in an uncollectible amount. Since the account receivables are a source of cash inflow for a company, bad debts will impact the liquidity and true & fair statement of assets.
Therefore, the company requires a risk assessment procedure to ascertain doubtful debts so that assets can be represented at the most realistic value. Provision, reserve, or allowance for bad debt is created to allow a business entity to record its assets at the truest value.
A business entity can comply with the matching principle by calculating provisions for doubtful debts by recording the actual revenues earned and related expenses in the income statement. One thing that must be understood is that allowance for bad debts is not a risk mitigation tool. Instead, it is only helpful in the realistic recording of assets and risk assessment for any future bad debts.
Allowance For Doubtful Debts Vs. Bad Debts
Doubtful debts cannot be specified with a surety. They are account receivables having a probability of becoming uncollectible in the future. You cannot ascertain a specific invoice or specific debtor to be doubtful debt. It is done based on probability by creating a provision or allowance for doubtful debts. Provision for doubtful debt is a reserve calculated by different methods.
Bad debts are the account receivables clearly identified as uncollectible in the present or future time. The account receivables are credited by the amount of bad debt. The debtors who have become bad debts are removed from the accounts by passing an entry for bad debt expenses.
Estimation of Allowance For Doubtful Debts
The allowance for doubtful debts cannot be created without any analysis. You can use one of the several methods as discussed below:
- Based on the credit history of every debtor, you can assign a credit score to him. The debtors with high credit scores will be less risky, and those having low credit scores are more likely to become uncollectible receivables.
- Another method is using historical values of bad debts. The aging method of allowance calculation is based on the principle of historical value. You analyze the historical values of bad debts. Based on the values, you ascertain estimated bad debts, and an allowance is created.
- The third method is Pareto analysis. Based on the Pareto principle, 20% of all the variables are responsible for 80% of output. We apply this analysis to the debtors, which implies that 80% of account receivables are due from the 20% of customers. The large debtors are analyzed by assessing default risk for each customer. It is combined with the historical percentage method for the remaining 80% of debtors that collectively constitute the remaining 20% of account receivables. The total estimated amount is recorded as an allowance for doubtful debts.
Methods For Recognizing Doubtful Debt Reserve
A business entity requires a base value to rely on. Generally, there are two methods to ascertain the estimation to calculate the allowance for doubtful debts. Let’s discuss each of these.
Percentage Of Credit Sales Method
As the name implies, the business entity will set aside a percentage of credit sales as an allowance for bad debts. But how does a business entity reach that pre-defined percentage?
Following factors are considered for finding the percentage that will be deducted from all credit sales of a financial period:
- The credit history of a customer is assessed for estimating the probability of account receivable turning into bad debt
- According to the company’s collection policy and past history of bad debts, doubtful debts are calculated.
Once the percentage has been calculated, it will be multiplied by the total credit sales. The output will be recorded as an allowance for bad debts and deducted from the balance sheet’s account receivables.
For example, Company A has found a probability of 3% of all credit sales becoming uncollectible. It is based on the risk assessment. The total amount of the company’s credit sales for the financial period were $350,000.
We can calculate the provision for doubtful debts very conveniently.
Allowance for doubtful debt = $350,000 X 3%
Allowance for doubtful debt = $10,500.
Account Aging Method
The account receivable aging method also encompasses the historical value of bad debts in the past years. The aging schedule is made in this method for accurate estimation. The percentage is also calculated in this method by the historical values.
The amount calculated by the aging schedule tells the minimum amount of bad debt reserve that the business entity must maintain. Let’s understand this by the illustration.
Calculation For Allowance For Bad Debts
Allowance for doubtful debts = (2030 X 3%) + (250 X 5%) + (200 X14%) + (780 X 27%) + (250 X 50%)
Allowance for doubtful debt = 60.9 + 12.5 + 28 + 210.6 + 125
Allowance for doubtful debt = $437
In the aging schedule, $437 is the most important figure. It is the total estimate of expected bad debts. Therefore, this amount shows the minimum reserve to be kept. For instance, if the reserve account already has $137, only $300 additional is required.
Allowance For Doubtful Debts: Accounting Treatment
Now let’s look at the accounting treatment for the doubtful debts reserve.
The following entry will be passed for recording the provision.
What will be the solution for an existing debit balance of the ‘allowance for doubtful debt’ account?
There will be an adjustment of the new allowance for doubtful debts in that case. Let’s take the example from the above-discussed accounts aging schedule. One thing to be cleared is that the debit balance of the allowance for doubtful debts represents a negative balance. It signifies that the actual provision for bad debts in the previous financial year was less than that of actual bad debts.
Let’s say the account had an existing debit balance of $200. The minimum provision required is $437. Now we will add $437 and $200. A total amount of $637 will be credited against the bad debt expense. The following entry will be passed:
Allowance For Bad Debts In Balance Sheet
As discussed earlier, allowance for doubtful debt is a contra-asset to offset the account receivables. The allowance for doubtful debt is recorded as a negative balance under the account receivables in the company’s balance sheet. It is deducted from the total account receivables, and as a result, the most realistic value of account receivables is recorded in the company’s balance sheet.
Allowance for doubtful debts is a method for calculation of actual bad debts in the future. However, business entities can alternatively use the direct write-off method for recording bad debts. Under the direct method, the bad debt is only recorded when it is certain that an account has become uncollectible. The benefit of the allowance method over the direct write-off method is that the accrual-based accounting principles are not compromised.