Recoverability of some receivables may be doubtful although not definitely irrecoverable. Such receivables are known as doubtful debts. Prudence requires that an allowance be created to recognize the potential loss arising from the possibility of incurring bad debts.
The allowance for doubtful debts is created by forming a credit balance which is deducted from the total receivables balance in the statement of financial position. This works in the same way as accumulated depreciation is deducted from the fixed asset cost account. The allowance for doubtful debts reduces the receivable balance to the amount that the entity prudently estimates to recover in the future.
Allowance for doubtful debts consist of two types:
- Specific Allowance
- General Allowance
Specific Allowance
This is allowance created in respect of specific receivables which are known to be facing serious financial problems or have a trade dispute with the entity. Such balances may be identified by examining an aged receivable analysis which details the time lapsed since the creation of a receivable. Long outstanding balances identified from such analyses could be considered for inclusion in the allowance for doubtful debts.
The difference between the treatment of a bad debt and a specific allowance for doubtful debt is that in the latter case, the receivable ledger of the specific debt is not removed in case the debtor actually pays whereas in the case of bad debts, the receivable ledger is reduced to nil. Also, specific allowance may not be created for the entire amount of the doubtful receivable but only a portion of it. For instance, if there is a 50% chance of recovering a doubtful debt in respect of a certain receivable, a specific allowance of only 50% may be required. On the contrary, bad debt is normally recognized in full.
General Allowance
Past history of a business may show that a portion of receivable balances is not recovered due to unforeseen circumstances. Therefore, it may be prudent to create a general allowance for doubtful debts in addition to the specific allowance. The general allowance may be calculated on the basis of past experience concerning recoverability of debts.
The practice of creating general provisions is on the decline after revisions in the International Financial Reporting Standards (IFRS). Specifically, IAS 39 prohibits creation of general provisions on the basis of past experience due to the subjectivity involved in creating such an estimate. Instead, reporting entity is required to carry out impairment review to determine the recoverability of the receivables and any associated allowance.
Next page contains detail on the accounting of provision for doubtful debts.
