Bad Debt Provision
A bad debt provision, also known as an allowance for doubtful accounts or an allowance for bad debts, is an estimation of the amount of accounts receivable that a business expects to be uncollectible. This provision is a contra-asset account that reduces the total accounts receivable reported on the balance sheet to reflect the net realizable value, which is the amount the company realistically expects to collect from its customers.
The bad debt provision is created based on historical data, industry trends, or specific knowledge about certain customers’ financial situations. By estimating and recording the bad debt provision, a business can better reflect its financial position and ensure that its income statement shows a more accurate representation of the revenue earned during a given period.
Example of a Bad Debt Provision
Let’s assume that XYZ Company, a small electronics retailer, has $150,000 in accounts receivable for the month of June. Based on historical data, the company estimates that 4% of its accounts receivable will be uncollectible.
Here’s how XYZ Company would calculate and record the bad debt provision:
- Calculate the bad debt provision: $150,000 (accounts receivable) × 4% (estimated uncollectible percentage) = $6,000.
- Record the bad debt provision on the balance sheet: XYZ Company would report the accounts receivable as $144,000 ($150,000 – $6,000) to reflect the net realizable value, considering the $6,000 bad debt provision.
- Record the bad debt expense on the income statement: XYZ Company would also record a bad debt expense of $6,000 for June, which would reduce its revenue for the month.
By estimating and accounting for the bad debt provision, XYZ Company can better reflect its financial position and ensure that its income statement provides a more accurate representation of the revenue earned during June. This allows management and investors to make more informed decisions based on the company’s financial performance.