Doubtful Debts are debts which are unlikely to be recovered due to dispute over supply. To avoid overstating the assets (Accounts Receivable), a portion of the receivable is set aside as a doubtful debts allowance. When debts are unrecoverable, debts turn bad — bad debts.
In provision method, it is common to provide 3% to 5% of the accounts receivable as a doubtful debts allowance (Provision for Doubtful Debts).
Assuming, as of 31 Dec 2013, you have an account receivable of 100,000, based on a 5% doubtful debts allowance, the journal entry will be:
Debit Doubtful Debts expenses 5,000
Credit Provision for Doubtful Debts 5,000
Doubtful debts allowance is usually provided during the year end closing. If there are no changes in the accounts receivable as of the financial year end closing, then no additional provision for doubtful debts are required.
In 2014, current financial year, you have a bad debt of 10,000. You pass a journal to credit the accounts receivable and debit the bad debts expense account.
Assuming there is no further activities in the accounts receivable account; then the updated accounts receivable will be 90,000 (100,000 – 10,000). The doubtful debts allowance as of the current year end closing will be 4,500 (90,000 x 5%).
Hence, you need to reduce the provision for doubtful debts by 500 (5000 – 4500). A journal can pass to debit the provision for doubtful debts and credit the doubtful debt expenses.
You should consider consulting your accountant regarding the provision for doubtful debts and bad debts expenses for your business.
We shall discuss further in our future post about the method used for the provision for doubtful debts and handling of bad debt expenses in both the Quickbooks and MoneyWorks accounting software.