Revenue also referred to as sales or turnover is the total amount of income that a business has earned through the sale of goods or services to the public.
According to the matching principle and accrual system of accounting, revenue is recognized or the sale is made when the revenue is earned i.e. earlier of:
- Delivery of goods to the customer.
- Goods are made available to the customer.
Hence there are two types of sales: cash sales and credit sales. As the name suggests, cash sales are when payment is collected at the time of sale. On the contrary, credit sales are when revenue is accrued.
The sale is made but the payment is collected at a later time in the future. Hence, a background check should be made for every customer making bulk purchases on credit in order to avoid losses. The entry for credit sales is:
As per the prudence concept, revenue shall only be realized when it is certain whereas expenses shall be recognized when they are probable.
This concept exists to avoid overstating the profit or understating the expense. Hence a true and fair view of the financial position of an entity is shown.
Prudence concept applied to sales:
Now when we talk about credit sales, we recognize it when we are certain of collecting the amount i.e. the accrued revenue. However, the chances of fraud still exist.
Hence, at the yearend, an estimate is calculated as a percentage of accounts receivable or sales for the year. This estimate is reported as an operating expense reducing the net income.
It is treated as per the prudence concept and the matching principle. The probable loss of income related to the sales made this year is reported as an expense reducing the uncertain revenue recorded as sales.
Since the provision is a contra asset account, in the balance sheet of the entity, accounts receivables are reduced by provision for doubtful debts for the year.
The net amount of accounts receivable is then the amount the company expects to receive only.
Provision/allowance for doubtful debt:
What is the provision?
A provision is a liability of an uncertain amount of time. A provision for doubtful debt is an upcoming loss that would be incurred in the future at an uncertain time.
Even the amount of such expense would be uncertain since it is an estimate. A provision is to be recorded as an expense if all the following criteria are met:
- A present obligation (loss of income) has arisen as a result of a past event (credit sales),
- payment is probable (more likely than not),
- the amount can be reliably estimated (percentage of sales or accounts receivable).
The provision for doubtful debt is used in the allowance method of dealing with the bad debt expense.
In conclusion, provision or allowance for doubtful debt is an estimated amount of invoices that would be uncollectible.
Another point to note here is that since these are estimates, we are unsure of which invoice would default exactly.
Hence we can’t credit the accounts receivable account or the accounts receivable subsidiary ledger as a result of which a contra account is created known as the provision for doubtful debts account.
The entry passed at every year-end regarding the provision is as follows:
Cr_Provision for doubtful debts
In the future, when some accounts actually default and the doubtful debts become bad debts the following entry is booked:
Dr_Provision for doubtful debts
Cr _Accounts Receivable
The provision or reserve account is reduced with a debit entry whereas the accounts receivable accounts are finally credited since we know the exact invoices that have been defaulted.