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As a small business owner, you will inevitably be faced with clients not paying the money you are owed. Small businesses must account for this in their balance sheet to avoid serious financial problems as a result of bad debt. This is why we've compiled this guide to creating a provision for doubtful debts and how to calculate it.
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Provision for doubtful debts - explained
The provision for doubtful debts, often described as the provision for losses on accounts receivable or bad debt provision, describes the estimated amount of doubtful debt likely to be written off in a given period. It acts as an allowance for bad or doubtful debts. You can create either a specific or general allowance for bad debts. The former refers to specific debt that is likely to be doubtful due to eg financial problems, while the latter refers to a general percentage of accounts receivable that are estimated to need writing-off based on experience. It is advisable to include these figures on your business's balance sheet as it informs the overall financial state of your business.
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Calculating the provision for doubtful debts
Usually, these calculations would be based on historic experience. When entering your allowance for doubtful debts, there’ll be two ledger accounts for the provision for doubtful debt and the provision for doubtful debt – adjustment. While the former refers to the allowance for accounts receivable to be written off, the latter refers to any changes made to this allowance. When creating or increasing a provision for doubtful debt, you do it on the ‘credit’ side of the account. When decreasing or removing the allowance, you do it on the ‘debit’ side. When encountering an account receivable that is unlikely to be paid, this gets eliminated against the bad debt provision. Such receivables can be logged in a journal entry that debits the provision for bad debts and credits the accounts receivable account.
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Example
Company X has a total of GPB 50,000 account receivables at the end of the year. It decides to create a provision for doubtful debts that will be 1% of the total receivables balance. You then calculate the provision for bad debts as follows: GPB 50,000 x 1% = GPB 5,000. This would be entered in a journal like this:
Account$DrCr Provision for doubtful debts - adjustment5,000X Provision for doubtful debts5,000 X
By the end of the next year, Company X's total receivables amount to GPB 70,000. They, therefore, need to increase the provision for doubtful debts to GPB 7,000 (GPB 70,000 x 1% = GPB 7,000). In their records, the adjusted allowance will look like this:
Account$DrCr Provision for doubtful debts - adjustment7,000X Provision for doubtful debts7,000 X