What is the Provision for Doubtful Debts?
The provision for doubtful debts is the estimated amount of bad debt that will arise from accounts receivable that have been issued but not yet collected. It is identical to the allowance for doubtful accounts. The provision is used under accrual basis accounting, so that an expense is recognized for probable bad debts as soon as invoices are issued to customers, rather than waiting several months to find out exactly which invoices turned out to be uncollectible. Thus, the net impact of the provision for doubtful debts is to accelerate the recognition of bad debts into earlier reporting periods.
Accounting for the Provision for Doubtful Debts
A business typically estimates the amount of bad debt based on historical experience, and charges this amount to expense with a debit to the bad debt expense account [which appears in the income statement] and a credit to the provision for doubtful debts account [which appears in the balance sheet]. The organization should make this entry in the same period when it bills a customer, so that revenues are matched with all applicable expenses [as per the matching principle].
Later, when a specific customer invoice is identified that is not going to be paid, eliminate it against the provision for doubtful debts. This can be done with a journal entry that debits the provision for doubtful debts and credits the accounts receivable account; this merely nets out two accounts within the balance sheet, and so has no impact on the income statement. If you are using accounting software, create a credit memo in the amount of the unpaid invoice, which creates the same journal entry for you.
It is highly unlikely that the provision for doubtful debts will always exactly match the amount of invoices that are actually unpaid, since it is only an estimate. Thus, you will need to adjust the balance in this account over time to bring it into closer alignment with the ongoing best estimate of bad debts. This can involve an additional charge to the bad debt expense account [if the provision appears to initially be too low] or a reduction in the expense [if the provision appears to be too high].
Presentation of the Provision for Doubtful Debts
The provision for doubtful debts is an accounts receivable contra account, so it should always have a credit balance, and is listed in the balance sheet directly below the accounts receivable line item. The two line items can be combined for reporting purposes to arrive at a net receivables figure.
Terms Similar to the Provision for Doubtful Debts
The provision for doubtful debts is also known as the provision for bad debts and the allowance for doubtful accounts.
At the end of the financial year when books of accounts are closed, certain provisions need to be created. The practice of creating provisions is in line with Matching Principle of Accounting. According to Matching principle, expenses incurred in a financial year must be recorder in the same financial year to which it relates. However, sometimes the exact amount of expense is not known at the end of financial year. Provision is created in order to recognize such accrued expenses for which exact amount is not yet known. Hence, a Provision for expense basically recognizes the liability of an organisation towards expenses related to a financial year. Please refer to the below points to further understand provisions.
Provision is an account which recognizes a
liability of an entity. Such liabilities are normally related to unpaid expenses. Hence, the recording of the liability in the balance sheet is matched to an expense account in the entity's P&L A/c.
The main purpose of a provision is to adjust the current year balance sheet and P&L A/c so that they reflect true and fair view of an entity's financial position. If expenses accrued in a financial year are recorder in the next year in which invoices are received, the
statements of accounts would be misleading to the stakeholders.
Provisions and International Financial Reporting Standards [IFRS]:
Guidelines pertaining to Provisions are prescribed in "IAS 37: Provisions, Contingent Liabilities and Contingent Assets" According to IFRS [IAS 37] Provision is defined as "A provision can be a liability of uncertain timing or amount. A liability, in turn, is a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits"
When to create a Provision?
There are certain factors which must be kept in mind while determining when provision for certain expense should be created. Not all obligations can be treated as provisions.
An entity has a present obligation as a result of a past event occurred in relation to a financial year in which provision is to be
created.
It is probable that obligation shall cause an outflow of monetary resources to settle such obligation in next financial year.
A reliable estimate can be made of the amount of the obligation at present.
The standard also provides for measurement methods of provisions. The standard requires that the entity recognizes a best estimate of the amounts needed to settle the obligation.
Accounting Treatment of
Provisions:
As discussed, the purpose of creating provision is to recognize present obligation of an entity in relation to an expense whose benefits are received in the current financial year but exact amount of expense is not yet known. In accounting terms, a provision account is a current liability and shown on the Liability side of the balance sheet. Similarly, the expense for which provision is created is recognized in the same financial year and recorded on debit side of
P&L Account.
- Journal Entries for Provisions for Expenses at the end of Financial Year:
Date | Particulars | Dr. | Cr. | Under Group |
31st March | Expense A/c | Indirect Expense | ||
Provision |
- Effect on respective Ledgers:
Expense Ledger | |||
Particulars | Debit | Particulars | Credit |
To Provision for Expense | By P&L Account | ||
Provision for Expense Ledger |
Provision for Expense Ledger | |||
Particulars | Debit | Particulars | Credit |
By Expense | |||
To Balance C/F |
Profit & Loss Account | |||
Particulars | Debit | Particulars | Credit |
To Expense | |||
Balance Sheets | |||
Liability | Amount | Assets | Amount |
Provisions: | |||
Provision for Expense |
- Reverse Entry in next financial year:
Date | Particulars | Dr. | Cr. | Under Group |
1st April | Provision for Expense A/c Dr. | Provision | ||
Indirect Expense |
- Entry when actual invoice is received for the expense:
Date | Particulars | Dr. | Cr. | Under Group |
Date of Invoice | Expense A/c Dr. | Indirect Expense | ||
Sundry Creditors |
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