What are ‘doubtful debts’?
A doubtful debt occurs when a business provides for the possibility that a debt or debts may not be paid. The major difference between a doubtful debt and a bad debt is that the business is not writing off the doubtful debt completely. It is just making sure that the accounts accurately reflect the fact that the business possibly will not receive all of the money owed to it.
There are two possible ways being doubtful about debts:
- Specific doubtful debts: A business may be aware that a particular debtor is in financial trouble, or has a debtor who disputing its liability to pay the debt. The debtor may not have entered into an insolvency process or the dispute may be settled on favourable terms, therefore, the business has not totally given up hope of receiving payment, but the business wants to show that it may not receive the amount owed.
- General doubtful debts: A business may not have information on specific debts being doubtful, but perhaps knows that the market generally is not doing well and wants to make a general provision for a certain percentage of its debtors not to pay, e.g. it is estimated that 10% of its receivables may not be paid.
A business could decide to make a specific provision or a general provision, or a combination of both, to quantify its doubts and express them as an actual figure. This doubtful debt figure will be shown as the balance on an account called ‘Provision for Doubtful Debts’. The amount allocated to the provision for doubtful debts account is re-calculated at each year-end based on the business’ knowledge of its debts at that time. It might increase, reduce or stay the same compared with the previous year’s provision.
A provision account provides some cushioning for the business. Such an account can be viewed as a mechanism by which the business can ring-fence a certain amount of its net asset value, just in case it transpires that the doubtful debts need to be written off.
Showing Doubtful Debts as Expenses in the Profit and Loss Account
In future, a doubtful debt may be written off as a bad debt and become a real cost to the business. Because of this, doubtful debts are accounted for in the same expense account in the Profit and Loss Account as bad debts, a ‘Bad and Doubtful Debts’ expense account.
As we saw previously, the ‘bad debts’ element of this account should be categorised as an expense because they represent a cost to the business. However, doubtful debts represent potential costs which the business may (or may not) incur. it would, therefore, be wrong to show the whole amount of a business’ provision for doubtful debts as an expense. Instead, only the increase (if any) in the provision for doubtful debts over the amount of the previous year’s provision is treated as an expense.
Provision for Doubtful Debts on the Balance Sheet
The Provision for Doubtful Debts is treated as a liability on the Balance Sheet. As a matter of presentation, it is shown in a different way from other liabilities
and is ‘matched’ to the asset it most directly affects, the receivables asset account.
Example
Cocost Catering Wholesale (‘Cocost’) is a newly formed business, whose first accounting period ended on 31 December 2018.
Year end 2018 : At the end of 2018, Cocost’s receivables amount to £95,000. Cocost believes that one of its debtors, Burgerama Ltd (‘Burgerama’), is on the brink of insolvency and it is unlikely that they will pay their outstanding invoice of £750. Cocost makes a specific provision for doubtful debts for this £750.
In addition, Nightingales decides that it is likely that 2% of the remaining receivables may never be paid. Cocost therefore wishes to create a general provision of £1,885 for doubtful debts (£94,250,000 x 2% = £1,885).
So the total Provision for Doubtful Debts at the end of Year 2018 is £2,635.
As Cocost is a new business, the provision for doubtful debts at the start of Year 1 was £0. Therefore, at the end of Year 1 there has been an increase in the provision from £0 to £2,635. This means that the whole of this £2,635 increase is treated as an expense and must be included in the balance of the Bad and Doubtful Debts account in the Profit and Loss Account.
Year end 2019: When preparing the financial statements for 2019, Cocost decides that the total Provision for Doubtful Debts should be £3,250. This represents an increase of £615 from the previous year (£3,250 – £2,635= £615).
The increase of £500 is treated as an expense this year. By increasing its provision, in effect, Cocost is £615 ‘worse off’ than it was last year. Therefore, £615 is added to the Bad and Doubtful Debts Expense in the Profit and Loss Account.
Year end 2020: At the end of 2020, Cocost decides that trading conditions have improved and decides to reduce the total Provision for Doubtful Debts to £2,500.
A decrease in the Provision for Doubtful Debts reduces expenses. Therefore, when preparing the Profit and Loss Account for 2020, the Bad and Doubtful Debts expense is reduced by £750 (£3,250 – £2,500)