Allowance for doubtful debt:
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 method.
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 respectively.
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:
- Accounts Receivable
- 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
Bad Debts A/C $3,000
Provision for Bad debts $3,000