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Doubtful debts are customers whose payment of their invoices is uncertain. For businesses this is an important concept, as it directly impacts cash flow and the annual financial statements. In this article you will learn what doubtful debts are, how to record them on the balance sheet and how to handle write-offs in accounting.
Table of contents:
Doubtful debts are outstanding receivables where it is uncertain whether the customer will pay. In practice, this often refers to invoices that have been overdue for a long time, or customers known to be in financial difficulty.
There are three types of debtors:
| Types of debtors | Definition |
|---|---|
| Ordinary debtors | Customers with an outstanding invoice who are still expected to pay. There are no signs that payment is at risk. |
| Doubtful debtors | Customers where payment is uncertain. Often these are invoices long overdue or clients with financial problems. |
| Bad debts | Customers who certainly will not pay, for example due to bankruptcy or prolonged default. This receivable must be written off completely. |
Doubtful debts appear on the balance sheet under current assets. To present a realistic picture, businesses often create a provision for doubtful debts. This shows that not all receivables are likely to be collected.
See the example below, where you record doubtful accounts receivable on the balance sheet:
Explanation:
This treatment aligns with the general accounting principle of showing bad and doubtful debts separately for clarity.
The provision for doubtful debts is a reservation on the balance sheet. This means you recognize the risk that part of your receivables may never be collected. You reduce your asset position with an estimate of this potential loss, giving your financial statements a more accurate picture.
An allocation (or dotation) is the amount you add to this provision. As soon as there is a real risk that invoices will not be paid, you record the allocation as an expense. This is sometimes compared to the difference between allowance for doubtful accounts vs bad debt expense: the allowance adjusts the balance sheet, while the expense impacts the income statement.
When a risk arises that a debtor will not pay, you record this with an allocation to the provision for doubtful debts. You then already record a loss in the income statement, while setting aside a provision on the balance sheet.
Example allocation journal entry:
Before and after allocation
If later it appears that the debtor indeed does not pay, you do not need to recognize the loss again. In that case you write off the invoice against the earlier provision.
Example write-off journal entry:
Before and after write-off
This ensures that the same loss is not counted twice. It also clarifies the difference in handling bad debts and provision for doubtful debts in the balance sheet.
If a debtor proves uncollectible, you record the amount as a definitive loss. This means the receivable is written off completely. This is often referred to as bad and doubtful debts journal entry or definitive write-off.
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The provision is always recorded exclusive of VAT, because VAT is already processed at declaration.
As soon as there is a real risk that a debtor will not pay, you may record a provision.
Doubtful debts are uncertain, bad debts are definitively uncollectible.
An allocation lowers profit but gives a more accurate picture of your financial position.
