Provisions for bad debts are handled by performing journal entries in businesses. A business often plans for a certain portion of its accounts receivable to be uncollectible. Companies take actions, through provisions, to plan for this. It is hard to know exactly what accounts will not pay their bills, but through analyzing past experiences, companies calculate amounts they believe will turn out to be uncollectible.
A bad debt is a bill that is considered uncollectible debt. Determining when an account is a bad debt is the complicated part. A provision for bad debts simply refers to the way a company plans for these uncollectible amounts.
The most common provision for bad debts is an account called the allowance for bad debts. This account is also often called the allowance for doubtful accounts or allowance for uncollectible accounts. This account is considered a contra-asset account. Contra-asset accounts offset an asset account. In this case, this provision offsets a company’s accounts receivable account. In other words, the allowance for bad debts account reduces the company’s accounts receivable account. When the difference is found in these two account balances, it is called the net realizable value of accounts receivable. Another provision for bad debts is through an expense account called bad debts expense or uncollectible account expense.
Writing off Bad Debts
Companies use either the cash basis or accrual basis when recording bad debts. Companies operating under the cash basis generally use the direct write-off method. Under this method, when an account is considered uncollectible, it is written off the books at that time. Using the direct write-off method, no provision is made prior to this. The allowance method is more commonly used, especially in businesses operating under the accrual basis. Under this method, provisions are made in advance to plan for these circumstances. Companies calculate an amount believed to be uncollectible and it is recorded in the accounting records prior to the bad debt actually occurring.
Calculating the Provision
Companies use several methods when calculating the amount of the provision. One method is through analyzing past records and experiences of accounts receivable and uncollectible amounts. Another method used by companies is a fixed percentage of debt. After it is calculated, it is recorded on the books by debiting bad debts expense and crediting allowance for doubtful accounts.