Definition of Provision for Doubtful Debts

Written by marquis codjia
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Definition of Provision for Doubtful Debts
Doubtful debt indicates accounts receivable that a firm believes it may not recover. (debt defined image by Christopher Walker from Fotolia.com)

A company's top leadership generally reviews trends in customer defaults to establish adequate and functional credit risk management strategies. Doubtful accounts, or bad debt, are amounts that a firm believes it may be unable to recover based on a customer's payment history or delay in paying for goods or services.

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Definiton

A corporate sales and accounts receivable department head records as bad debt an invoice amount that a customer cannot pay because of bankruptcy or temporary monetary problems. She writes off, or records as a loss, bad debt accounts after a period of time.

Credit Risk and Doubtful Debt

Credit risk is the loss possibility resulting from a counterparty's (business partner's) inability to repay a loan on time or fulfil a financial obligation, other than a loan, when it becomes due. Credit risk is inherent in corporate transactions and often interrelates with doubtful debts. Credit risk and bad debt expense are correlated because a counterparty, such as a customer or a supplier, generally does not repay a loan or pay for received goods due to credit problems.

Allowance for Doubtful Accounts

The allowance for doubtful items account is also referred to as the provision for doubtful debts account. A corporate credit risk manager usually reviews a company's accounts receivable and ranks unpaid receivables as "high," "medium" and "low," depending on the loss expectation. Accounts rated as "high," "medium" and "low" are 120 days, 60 days and 30 days past due, respectively. Accounting managers usually record as bad debt expense customer receivables that are ranked "high."

Expert Insight

A company often may hire a specialist to help establish adequate credit risk management procedures and reduce doubtful debt in corporate revenue reporting systems. For example, a biomedical company can bring in a university statistician or financial risk manager to review customer credit-verification procedures and recommend options for improvement. The expert also can build complex math-based worksheets to automatically gauge a client's risk profile based on his historical and current financial statements, credit scores and business references.

Accounting for Doutbful Debt

U.S. generally accepted accounting principles, or GAAP, and international financial reporting standards, or IFRS, require a firm to record doubtful debts at market values. To illustrate, a New York-based car manufacturer ships £6 million worth of merchandise to five dealerships in the state. After 10 months, the company's credit manager discovers that two customers are experiencing significant financial problems and may file for bankruptcy. Both customers owe £3.6 million in total. A senior accountant at the firm debits the bad debt expense account for £3.6 million, and he credits the customer receivables account (asset) for the same amount. (In accounting parlance, crediting an asset account means reducing its balance.)

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