Provision for bad or doubtful debts
Defining a provision for bad or doubtful debts?
The definition for the provision for bad debts, or otherwise known as doubtful debts, is the estimated amount of bad debt that will arise from the trade receivables not yet collected. The application of the provision ensures that the financial statements give a true and fair view and that the financial statements are created using the accounting principle of prudence. In Credit Management, it is extremely important to assess the risk of your customer in order to prevent any bad debts from arising.
An allowance for doubtful debts can be either a specific debt which is felt will not be paid or a calculated amount based on past experience and a projection into the future, or both.
A specific allowance is one created in respect of identified receivables which have serious financial problems or have a dispute with the company. An examination of the aged debtor analysis can identify such receivables. The specific allowance may be calculated as a percentage of the total rather than the whole amount, depending on the risk analysis.
A general allowance was historically calculated based on past experience and used in addition to the specific allowance. However, use of general allowances has been on the decline since the introduction of the International Financial Reporting Standard IFRS 9 in 2018. IAS 39 prohibited the creation of a general provision based on past experience. As such, the Revenue would disallow general provisions but would usually allow specific allowances as tax deductible expenses (though not every time).
What should credit managers do?
It is therefore important in the current climate, for credit managers to make provision for specific doubtful debt based on identified customers and their financial ability to weather this storm. There are no shortcuts to this – risk assessment of the customer portfolio in the light of the Covid-19 crisis is imperative.
The IFRS requires a recognition of the impairment of financial assets in the calculation of expected credit loss (ECL). For trade receivables, companies can use a simplified calculation of the lifetime expected loss, normally one year. The input will be based on both historical performance as well as adjusting for forward-looking information such as recession, industry specific factors or the effects of the corona virus.
The aged debtor analysis will be a key tool as regards past information and the calculation of future default rates.