Definition of Doubtful Debt
Doubtful debt is a term used in accounting to describe an amount owed to an organization by a debtor that is expected to be uncollectible. This expectation can arise from various reasons such as the debtor’s financial instability, refusal to pay, or other credit issues.
Key Aspects
- Provision for Doubtful Debts: Organizations often create a provision for doubtful debts, which allocates a portion of receivables as potentially uncollectible based on historical data or specific assessments.
- Impact on Financial Statements: When a debt is considered doubtful, it is often reported as a provision on the balance sheet, reducing the total accounts receivable.
- Transition to Bad Debt: If a doubtful debt is later confirmed as uncollectible, it becomes a bad debt and is written off either against the provision or directly charged to the profit and loss account.
Examples
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Specific Assessment: A company notices that a major customer has filed for bankruptcy. Given the circumstances, the company decides to classify the amounts owed by this customer as doubtful and creates a specific provision for these debts.
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General Provision: A retail business, based on past experience, assumes that 2% of their total accounts receivable will be uncollectible. Consequently, they create a general provision for doubtful debts amounting to 2% of their current accounts receivable balance.
Frequently Asked Questions (FAQs)
What factors contribute to a debt being classified as doubtful?
There are several factors, such as the financial instability of the debtor, repeated payment delays, bankruptcy filings, and negative changes in the debtor’s operations.
How is a provision for doubtful debts determined?
Organizations determine provisions based on either historical data analysis (general provision) or specific evaluations of individual debtors’ ability to pay (specific provision).
What happens if a doubtful debt turns into a bad debt?
When a doubtful debt becomes a bad debt, it is written off against the previously created provision or charged directly to the profit and loss account if no provision exists.
Can doubtful debts impact a company’s profitability?
Yes, creating provisions for doubtful debts decreases the accounts receivable and increases expenses, which can lower the net income.
How does IFRS handle doubtful debts?
Under the International Financial Reporting Standards (IFRS), doubtful debts are accounted for using the Expected Credit Loss (ECL) model for impairment, which requires forward-looking estimations.
- Bad Debt: A debt that has been confirmed as uncollectible and is written off the company’s accounts.
- Provision for Bad Debts: An accounting entry representing the estimated funds set aside to cover bad debts.
- Accounts Receivable: The money owed to a business by its customers for goods or services delivered on credit.
- Profit and Loss Account: A financial statement summarizing revenues, costs, and expenses incurred during a specific period.
Online References
- Investopedia: Bad Debt
- IFRS 9: Expected Credit Losses
- AccountingTools: Doubtful Accounts
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- “Financial Accounting” by Walter T. Harrison Jr., Charles T. Horngren, C. William (Bill) Thomas
- “Principles of Accounting” by Belverd E. Needles and Marion Powers
Accounting Basics: “Doubtful Debt” Fundamentals Quiz
### What is the key difference between a doubtful debt and a bad debt?
- [ ] A doubtful debt is fully written off.
- [x] A doubtful debt is expected to be uncollected but not yet confirmed.
- [ ] A doubtful debt is collected within a year.
- [ ] A doubtful debt increases accounts receivable.
> **Explanation:** A doubtful debt is expected to be uncollectable based on specific criteria but has not yet been confirmed as a bad debt, which is fully written off.
### How does a company usually account for doubtful debts on its financial statements?
- [x] By creating a provision for doubtful debts
- [ ] By increasing the accounts payable
- [ ] By writing off the entire accounts receivable
- [ ] By adjusting the inventory values
> **Explanation:** Companies create a provision for doubtful debts to account for expected uncollected receivables, which affects the accounts receivable balance on the financial statements.
### What happens to doubtful debts if they are later confirmed as uncollectible?
- [ ] They are increased in the accounts receivable.
- [x] They are written off as bad debts.
- [ ] They are transferred to accounts payable.
- [ ] They are capitalized.
> **Explanation:** If doubtful debts are later confirmed as uncollectible, they are written off as bad debts, either against the provision or directly charged to the profit and loss account.
### What is one method of estimating the provision for doubtful debts?
- [ ] Calculating future sales projections
- [ ] Evaluating current liabilities
- [x] Applying a percentage based on historical collection data
- [ ] Reviewing short-term investments
> **Explanation:** One common method to estimate the provision for doubtful debts is to apply a percentage based on historical collection data, reflecting the average uncollected receivables.
### What impact does a provision for doubtful debts have on a company's net income?
- [ ] It increases net income.
- [x] It decreases net income.
- [ ] It has no impact on net income.
- [ ] It can either increase or decrease net income randomly.
> **Explanation:** Creating a provision for doubtful debts increases expenses, which decreases the net income.
### How are doubtful debts classified under IFRS?
- [ ] As liabilities
- [x] Using the Expected Credit Loss (ECL) model
- [ ] As short-term investments
- [ ] Under capital assets
> **Explanation:** Under IFRS, doubtful debts are classified using the Expected Credit Loss (ECL) model, which incorporates forward-looking estimations for impairment.
### A specific customer has filed for bankruptcy. How should the organization account for the amount owed by this customer?
- [x] By creating a specific provision for the debts
- [ ] By immediately writing off the entire amount
- [ ] By reducing the inventory levels
- [ ] By booking it under accounts payable
> **Explanation:** The organization should create a specific provision for the debts owed by the bankrupt customer, reflecting the expectation of uncollectibility.
### When does a doubtful debt become a bad debt?
- [ ] When it remains unpaid for over 5 years
- [x] When it is confirmed as uncollectible
- [ ] When the customer delays payment twice
- [ ] When the account balance is higher than a specific threshold
> **Explanation:** A doubtful debt becomes a bad debt once it is confirmed as uncollectible, leading it to be written off against the existing provision or directly to the profit and loss account.
### Provision for doubtful debts is shown on which financial statement?
- [ ] Income statement
- [ ] Cash flow statement
- [x] Balance sheet
- [ ] Statement of changes in equity
> **Explanation:** The provision for doubtful debts is shown on the balance sheet as a reduction in the total accounts receivable.
### Why is creating a provision for doubtful debts important for an organization?
- [ ] It boosts immediate cash flow.
- [ ] It increases the number of customers.
- [ ] It reduces the overall debt.
- [x] It provides a more accurate picture of receivables and financial health.
> **Explanation:** Creating a provision for doubtful debts is important as it provides a more accurate picture of the organization’s receivables and financial health, adjusting for expected uncollected amounts.
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