If you’re looking to progress in your accounting career, you need a clear idea of how to make provisions for doubtful debts.
Most organisations expect to be paid for the products or services they sell. Most, however, don’t expect payment straight away; in fact, when selling business to business, it’s more typical to use credit accounts.
A credit account means that as long as a customer passes a credit check, they will be allowed to pay for the goods in 30 days’ time. Not having to pay straight away can be mutually beneficial for companies and their customers, as it means that business transactions can go ahead even when customers don’t have the money there and then.
The risk of debt
There is, however an element of risk when selling on credit. Some customers won’t pay and the debt is then written off. This is a bad debt, and means the company has to take the sale out of the accounts even though the customer has had the product or service.
When preparing a set of accounts, accountants use the concept of prudence. This means looking at potential risks, and considering what the worst case scenario could be. As part of this concept, it is important for the accountant to put a provision into the accounts for doubtful debts, which is the amount the company thinks may never be paid from customers who have purchased on credit.
It is essential that this is done at the point of raising invoices to customers, so that it can be recognised in the accounts in earlier reporting periods, rather than only when debt actually occurs.
Working out provision for doubtful debts
Provision for doubtful debts is usually calculated as a percentage of the debtors (outstanding customers) at the end of the year. This is normally estimated based on previous experience, with entries being made as debits to the bad debt expense account, and credits to the provision for doubtful debts account. This is normally done as an accounting adjustment.
For example, if the outstanding debt at the end of the year is £32,400, we could estimate 2% of these debts won’t be paid, which works out at £648. If we know a customer will not be paying, then this needs to be written off as a bad debt.
As you can see, then, selling on credit can encourage trade and be helpful to businesses and the economy, but there is an element of risk, which is why we enter a provision for it.