Accounting – 4.4 Irrecoverable debts and provision for doubtful debts | e-Consult

Provision for Doubtful Debts is an estimate of the amount of accounts receivable that are not expected to be collected. It is a contra-asset account, meaning it reduces the value of the Accounts Receivable balance on the Statement of Financial Position. It's an accounting policy choice based on historical data and assessment of current customer creditworthiness.

Bad Debt Expense is the actual amount of debt that is deemed irrecoverable and written off. It is an expense recognised in the Profit and Loss Account. It represents the loss incurred due to debts that cannot be collected.

How the Provision for Doubtful Debts affects the financial statements:

• Statement of Financial Position (Balance Sheet): The Provision for Doubtful Debts reduces the carrying value of Accounts Receivable. This provides a more realistic valuation of assets.
• Profit and Loss Account (Income Statement): The Bad Debt Expense (which is the difference between the total credit sales and the Accounts Receivable balance less the Provision for Doubtful Debts) is deducted from the gross profit to arrive at the net profit. This provides a more accurate representation of the profitability of the business.

By using a Provision for Doubtful Debts, the business adheres to the accruals accounting principle, matching expenses (bad debt expense) with the revenue (credit sales) generated in the same period. This provides a more accurate and transparent view of the business's financial performance and position.