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Doubtful debts are customers whose payment of invoices is uncertain. For businesses this is an important concept, as it directly affects cash flow and the annual accounts. In this article you will learn what bad and doubtful debts are, how you record them on the balance sheet and how to handle write-offs in accounting.
Table of contents:
Bad and doubtful debts are outstanding receivables where it is uncertain whether the customer will pay. In practice, this often refers to invoices that have been overdue for a long time, or customers with known financial problems.
A distinction is made between three categories of debtors:
Explanation:
This treatment is part of bad and doubtful debts accounting and helps give a true and fair view of the company’s financial position.
The provision for bad and doubtful debts is a reservation on the balance sheet. This means you allow for the risk that part of your receivables may never be collected. You reduce your asset position with an estimate of this possible loss, giving your accounts a more accurate picture.
An allowance for doubtful debts is the amount you add to this provision. As soon as there is a real risk that invoices will not be paid, you book the allowance as an expense. This is the double entry for provision of doubtful debt: it affects both the income statement and the balance sheet.
When a risk arises that a debtor will not pay, you record this with an allowance for doubtful debts. You then already book a loss in the profit and loss account, while creating a provision on the balance sheet.
Example allowance journal entry:
Before and after allowance
If later it appears that the debtor indeed does not pay, you do not need to recognise the loss again. In that case you write off the invoice against the earlier provision.
Example write-off journal entry:
Before and after write-off
This approach prevents the same loss being recognised twice. It also clarifies what is provision for bad and doubtful debts and how to handle it in practice.
If a debtor proves uncollectible, you book the amount as a definitive loss. This means the receivable is written off completely. This is often referred to in bad and doubtful debts definition as the final stage of write-off.
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The provision is always recorded exclusive of VAT, because VAT is already processed in the return.
As soon as there is a real risk that a debtor will not pay, you may record a provision.
Doubtful debts are uncertain, bad debts are definitively uncollectible.
An allowance lowers profit but gives a more accurate picture of your financial position.
