Why is the Provision for Doubtful Debts a Liability?

by Yumna
(Maldives)

Q: Why is the provision for doubtful debts a liability?

A: A provision is a loss or expense that will definitely occur in the future, but we don't know exactly how much or when the loss/expense will occur.

Usually a business decides (based on past records) that they expect a certain percentage of their debtors (receivables) not to pay them next year.

Let's say it's 5%. If their debtors come to $100,000, then they expect $5,000 to go "bad," and the real (net) debtors in their records will be $95,000 ($100,000 - $5,000).

The provision for doubtful debts (or provision for bad debts) is different to doubtful debts (or bad debts).

Doubtful debts or bad debts is an expense and has already occurred.

The provision is a future loss - a future loss that must be recorded as soon as it becomes likely to occur. This future loss is like owing someone. Sort of. So it is considered a liability. But a special type of liability.

In other words, doubtful debts or bad debts have already occurred - the debt is bad right now. For example, Joe Shmoe (debtor) owed you $500 and he just told you he is filing for bankruptcy and can't pay anything. So you record the loss (expense account) called doubtful debts or bad debts for the amount of $500.

The provision, on the other hand, is for debts that will definitely occur - but in the future. The debts are not bad yet, but we are certain that they will be bad. The provision is an estimate of bad debts in the future.

Please note that full lessons, examples and exercises about provision for bad debts and bad debts themselves are not available on this site, only in my basic accounting books.

Good luck!

Best,
Michael Celender

Comments for Why is the Provision for Doubtful Debts a Liability?

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Provision for Bad Debts should be called "Bad Debts Allowance"
by: Anonymous

Hi

I would like to comment on the fact that the word "provision" as defined by IAS 37 restricts provisions to present obligations resulting from past activities of uncertain amount or uncertain timing but for which a reasonable estimate can be made. This means provisions are in fact liabilities that have to be settled with an external stakeholder. The word "external" here is meant to suggest that the business owes another party (other than itself).

This makes the word "provision" undesirable for use when speaking of allowances such as depreciation or doubtful debts or bad debts. The reason is that such allowances do not constitute an actual obligation to an identifiable entity or stakeholder.

Many academics now view accumulated depreciation as a negative asset and this would fit the scenario of an accumulated allowance for bad or doubtful debts. In the Balance sheet, the accumulated depreciation is subtracted from cost to give the Net Book Value of the Non-current asset. Similarly, the accumulated allowance for bad debts is subtracted from debtors to give us the Net collectable debts.

So I would venture to say the allowance for bad debts is, in fact, a negative asset and not a liability. IFRS 9 chooses the term allowance for bad debts not provision for bad debts. The double entry you have described is absolutely correct it is just the terminology that I am commenting on. Thank you.

Hi there, this is an excellent point. Yes, the term "allowance for bad debts" is now in general use where there was "provision for bad debts" previously.

However, I'm not 100% certain that IAS 37 necessitates an identifiable external party as part of the definition (but perhaps I'm wrong on this). Like you said, it is defined along the lines of a present obligation resulting from past activities of uncertain amount or uncertain timing but for which a reasonable estimate can be made.

There certainly is still debate about exactly how to classify these unusual items like Accumulated Depreciation and Provision/Allowance for Doubtful Debts in terms of negative assets or liabilities. You make some excellent points here and you're right - it is important to get the terminology as accurate as possible.

Thank you very much for a very well-thought-out and well-written contribution.

Best,
Michael Celender

Provision for bad debt
by: Maminutes

Sir how we adjust provision for bad debt? Does it is expense when it adjusted down or up?

If you want to increase the provision you do:

Dr Bad Debts
Cr Provision for bad debts

And if you want to decrease the provision you do the opposite:

Dr Provision for bad debts
Cr Bad Debts

Best,
Michael Celender

Help
by: srey

1. Explain the purpose and logic behind a provision for doubtful debts, with particular reference to the timing of profits and losses arising from credit sales.

2. Give one example of a provision other than provision for bad debts and depreciation.

Provision for Bad Debts
by: Priji

Thanks for your explanation. But is it a current or non-current liability then?

Provision for doubtful debts, on its own, would technically be considered a current liability account, as it is the estimate of debts that will occur in the next year.

However, provision for doubtful debts is included in the balance sheet in the calculation of "Trade and other receivables." "Trade and other receivables" is your net debtors.

For example, let's say receivables/debtors are $50,000 and your provision for doubtful debts (what you are expecting to not receive in the future) is $4,000. So your "Trade and other receivables" would come to $46,000 ($50,000 - $4,000). "Trade and other receivables" is your net debtors. Same thing.

Best,
Michael Celender

Provision for doubtful debt in profit and loss a/c
by: Anonymous

Sir, why do we write provision for doubtful debts on debit side of profit and loss a/c, is there any logic?

This is because the debit entry is actually bad debts, which is an expense.

Entry is:
Dr Bad Debts
Cr Provision for Bad Debts

Best,
Michael Celender

Helped
by: Anonymous

Thank u sir, helped for my preparations.. keep up the great work.. Cheers from india!!

Provision for Bad Debt
by: Ambady, Kottayam

Sir, what is the nature of provision for depreciation account and what is the nature of provision for bad debts?

I think I explained enough about provision for bad debts already so I'm not explaining it again here.

In terms of "provision for depreciation," as far as I'm aware there is no such thing as this. There is something called "accumulated depreciation," which is the total of depreciation expenses for an asset up until the present time. This accumulated depreciation is simply the negative value of an asset. For example, the cost of a truck is $50,000 and its accumulated depreciation is $10,000, so it's true value (carrying amount) right now is $40,000.

Hope that helps!

Best,
Michael C.

Thanks a lot
by: Vandana Sharma

It cleared my doubt about provision for doubtful customers a liability. Now I'm not confused.

thanks a lot
by: kalyani

Thanks. Ur explanation is very helpful.

being clear
by: Mrs kaake

Thank you for the explanation. I always thought that provision for doubtful debt is a negative asset, your explanation is really helpful!

simple explanation
by: Anonymous

The explanation is very simple and understandable. Helped to clarify the doubts related to the topic.

A/c
by: Shahid s kamara

I think their are accounting specialist thanks a lot for giving me understanding

Thanks a lot.
by: iyke

Thanks for the simple and exccellent difinition because it is always hard to differenciat between doutful debt and bad debt.

Thank you!
by: jayah

Thanks very much! Helped me in one of my assignments.. Am always confused with bad debts,doubtful debts, & provision for doubtful debts. Your explaination is simple and very precise!

*happy* (^_^)

J

You're most welcome Jayah! Thanks for the positive feedback! :-)

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