When a company has a policy of selling goods on credit, a lot of times customers end up not paying the amount they owe to the company.
This expense is referred to as a bad debt expense and its treatment and reporting on the financial statements is a bit raveling.
The International Accounting Standards defines the procedure and methods to record bad debt expense. The Accounting Standards prefer to create a provision for bad debts expense on the basis of organizations past experience.
The estimated may be a percentage of total credit sales or total trade receivables balance. The main logic behind the creation of this provision is to accommodate the bad debts expense in the accounting period which they relate.
In the other methods matching concept is missing which is against the rules of accounting.
Provision for bad debt with example:
The doubt that some invoices are uncollectible is a forecasted expense. For example, there are 2000 customers who owe you an amount of $500,000. You estimate that out of these 2000 customers a few would fail to pay back a total amount of $25,000.
In the present, you don’t know out of the 2000 specifically which customer would fail to pay their dues but a probable expense of $25,000 has been estimated.
This implies that you would be unable to credit the accounts receivable unless you know the customers that are going to default.
In order to deal with this situation instead of waiting for the customers to be identified, a contra asset account is created against the accounts receivable which is also known as allowance for doubtful debt or provision for doubtful debt account. The entry passed to record this procedure is given below:
Bad debt expense DR xx
Provision for bad debt CR xx
The provision for doubtful debt account is created to reduce the accounts receivable balance to its net realizable value without having to credit it.
Since it is a contra asset account it has a credit balance as compared to the debit balance of accounts receivable.
It is reported on the balance sheet along with the accounts receivable. In our example given above, the following entry would have been passed:
Bad debt expense DR 25,000
Provision for bad debt CR 25,000
Hence, on the balance sheet a net amount of $475,000 would be shown which is the amount expected to be collected from the customers.
Importance of Allowance for Doubtful Debts:
A debit to the bad debt expense account meant that the amount would be reported as an operating expense on the income statement.
The allowance for doubtful debt account lets us report the bad debt expense as soon as the estimate is calculated and help us in portraying a true and fair view of the financial statements.
Let me explain how. The uncollectible invoices of the current year will be reported as bad debt at a later point in the future.
If we report this expense on the income statement at the time defaulting customers are identified this would understate the profit and overstate the expense for that year since the bad debt expense is not related to its revenue.
The bad debt expense is related to the revenue generated in the current year.
Hence in order to achieve the goal of matching principle, bad debt expense or doubtful debts should be recognized as soon as they are expected.
In conclusion, to be able to prepare financial statements as per generally accepted accounting rules, allowance for doubtful debt account must be accordingly maintained.