From the term ‘bad debts’ a bad image comes to mind. Something very bad or disgusting.
Does it mean that the debts which you have taken were terrible? Was a ‘bad’ decision to take those debts? OR, are those debts so bad that they keep haunting you in dreams? No, no, nothing like this, all this is not the meaning of bad debts.
In accounting & finance, bad debts mean those customers who purchased from you on credit terms and now are not paying to you. They are not paying even after reminders and emails, and they are not attending your calls also. The terminology is given as ‘bad’ because now the chances of recovery of such debts are meager or nil.
There are two main categories in this regard; one is ‘bad debts’, and the other is ‘provision for bad debts’. The provision for bad debts is also referred to as provision for doubtful debts.
Now we’ll discuss what are the implications if a customer does not pay you even after the due date of the payment, how it affects the company, it’s cash-flows, it’s financial statements and what are the roles of auditors in this regard.
In different industries, there is a different practice of the credit period offered to the customers. In retail, typically, there is no credit period. Most of the sales are on cash. Like if you go to a grocery store, you’ll have to pay (by cash or card), and in any case, the store will get the money quickly.
However, the store will not be paying it’s suppliers daily or at the time of purchase. These suppliers who supply their products to the store provide a credit period of, typically, one month or two months (or even three months) to the retail store.
Credit terms are not very common for retail customers in any industry. Whether you are buying a car or milk, as a retail customer, you’re likely to pay immediately. You’ll either pay the full amount in cash or arrange a loan through a bank or a credit card company. But in any case, the vendor will get the money instantly (or max in one or two days).
However, credit terms are more common when it comes to Business-2-Business (B2B) transactions.
External auditors are interested in making sure that the receivables presented on the balance sheet of the entity are good enough, i.e., this money will be received to the company, i.e., they are not ‘bad’. So, this is one of the areas auditors pay particular attention. It is a very judgmental topic, as well. How can someone tell if a specific customer will pay at the due date or not?
The term ‘bad debts’ refers to the receivables which are believed to be non-recoverable. Such debtors are declared as bad debts and then removed from the company’s receivables listing. The accounting entry for this would be to debit: bad debt expenses and credit: accounts receivables.
However, this rarely happens in practice. Usually, companies never credit their accounts receivables except in exceptional circumstances.
On the other hand, when the recover-ability of any debtor becomes suspicious or questionable, a provision is created in the books of accounts, ensuring correct accounting treatment. This provision is referred to as ‘provision for doubtful debts’ or ‘allowance for doubtful debts’. The accounting entry for this provision is debit: doubtful debts expense account and credit: allowance for doubtful debts.
The term of doubtful debts and bad debts is sometimes used interchangeably in practice.
The difference is that the receivables are not credited; instead, another account is created to reduce the balance of receivables. This is similar to provision for depreciation account.
It is important to note that the provision for doubtful debts and provision for depreciation expenses do not actually fall under the definition of ‘provisions’ as per IAS 37 Provisions, Accounting Policies & Accounting Estimates. However, the word ‘provision’ is used for these two items as a practice.
Creating a provision for doubtful/bad debts is a pain for the management of the company. As you understand now, that creating or increasing the provisions for doubtful debts results in increased expenses (and thus less profit) and decrease in the assets (lower receivables) in the balance sheet. It’s a double sword and management is keen to avoid this.
Most of the times, management would make assumptions and would try to convince it’s external auditors that a provision is not required. It would establish by different means that receivables are healthy and the company is going to collect this money.
It is important to note that the accounting standards do not provide any time frame for booking bad debt expenses or recording provisions. Accounting standards don’t specify that time duration, e.g., if a customer has not paid three months after the due date, then that customer is a bad/doubtful debt. No, there is no such time frame defined in the accounting standards. Instead, it is a judgmental call and varies from industry to industry.
Usually, in the construction industry, credit periods are more extended, and customers take significant time even after the due date to make the payment. So, this doesn’t necessarily mean that the customer is bad now. Especially when dealing with government clients or when dealing with contractors dealing with government clients, payments are usually slower than usual.
On the other hand, it is still possible that a customer is virtually certain as bad debt even before the due date of the payment. For example, if a customer goes bankrupt, then, there is a reasonable certainty that a provision is required to show the correct value of the receivable.
An essential concept in the provisioning of the bad debts is the aging of receivables. An aging of receivables is listing of time frame by which receivables are outstanding. For examples, how many (and which) receivables are outstanding for more than 30 days, more than 60 days and more than 90 days etc. There are separate columns prepared to represent aging of receivables. The longer a receivable is outstanding, the more doubtful is the recovery of that receivable (generally speaking). Below is a snapshot of how receivables aging looks like:
|G.L Code||Party name||Less than 30 days||Between 30-60 days||Between 61-90 days||More than 90 days||Total|
All figures are in US$.
Based on the above table, it can be seen that there is a total of $ 1,400 outstanding for more than 90 days. Now, how to calculate the provision for bad/doubtful debts. Calculation of provision for doubtful debts depends on a lot, as stated earlier, on the industry as well as on the company’s policy. There are no defined regulations in accounting standards (IFRS / US GAAP) for calculation of the provision for doubtful/bad debts.
Now, based on the company’s past practice and experience, it can choose to fully provide (100% provision) for balances outstanding for more than 90 days, or it may provide less provision. Company may also check further provisioning brackets like balances outstanding for more than 180 days or even more than 365 days and then calculate provision in those brackets.