What is a doubtful debt?
When a credit customer is expected to go bankrupt or has an unreliable profile, chances are he is going to not pay the amount he owes to us.
Such accounts receivable are referred to as doubtful debts or uncollectible invoices.
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 their 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 a 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 the 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 doesn’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 number of invoices that are certainly collectible.