Provisions: doubtful receivables, obsolescence and impairment

Provisions: doubtful receivables, obsolescence and impairment

No business collects one hundred percent of what it sells on credit, and no business sells every piece of merchandise it buys. There is always a customer who falls behind, another who disappears, and products that get damaged, go out of fashion or simply stop being ordered. Accounting cannot ignore those probable losses: if the books show as certain some collections and some inventories that in practice are not, the balance sheet will paint a stronger business than the one that really exists. Making a provision is exactly that: recognizing today, early and prudently, an expense for a loss that has not happened yet but looks probable.

In this lesson of the Kardex Tauro accounting manual you are going to understand what making a provision means, why prudence is an accounting principle and not just good advice, and how that idea applies to the two cases that affect a buying and selling business the most: the receivables from customers who probably will not pay, and the merchandise that lost value or can no longer be sold. We will see the journal entry for each provision, what happens when the risk disappears, what happens when the loss is confirmed, a complete numerical example of a provision for doubtful receivables based on the age of each debt, and the most common mistakes you should avoid in practice.

What making a provision means

Making a provision means recording, at the moment it becomes known, an expense for a loss that is considered probable even though it has not materialized yet. The word sounds like an expense, and it really is one, but one thing should be clear from the start: a provision is not money leaving the business and it is not savings. Nobody takes cash out of the till to keep it in a drawer labeled with the name of the late payer. A provision is an accounting record that recognizes that an asset is worth less than the books say, or that a probable obligation exists, and that therefore today's profit must be smaller.

Behind that record stands the principle of prudence. When the same fact can be read in two ways, one optimistic and one realistic, accounting chooses not to fool itself: it recognizes expenses and losses as soon as they become probable, and it recognizes income only when it is reasonably certain. If the loss looks probable, it is recorded today; if in the end it does not happen, the entry is reversed and the effect corrects itself. The opposite mistake, skipping the provision hoping that everything will work out, is the one that has driven to bankruptcy businesses that presented flawless balance sheets.

International accounting frameworks, known in their conceptual form as IFRS, follow exactly the same logic: when there is uncertainty, the balance sheet should not show overvalued assets or early profits. We will not quote standards with numbers here because they are not needed: what matters is the principle, and the principle is that a probable loss is recognized when it becomes known.

The most common provisions in a business

There are many kinds of provisions, from the ones that cover warranties offered to customers to the ones that cover claims or lawsuits against the business. All of them share the same structure: a present fact makes a future outflow of money or a future loss of value probable, and accounting recognizes it today. For a business that buys and sells, however, two provisions appear at almost every closing: the provision for doubtful receivables, because the business sells on credit, and the provision for inventory impairment or obsolescence, because the business buys merchandise. The following table summarizes how they behave.

Notice the pattern: in the three cases an expense is recognized immediately and a provision supports it, and in the three cases the provision can be reversed if the loss never happens. That pattern is the essence of this lesson.

Provision for doubtful receivables: customers who probably will not pay

When the business sells on credit, an asset is born: the receivable. That asset represents the right to receive money in the future. The problem is that not every right is fulfilled. Some customers pay late, some pay only part, and some never pay at all. If the books treated one hundred percent of the receivables as good, the asset and the profit would be overstated, because a part of those accounts will never turn into money.

The classic tool for measuring that risk is the aging analysis of the receivables, which groups the debts by how long they have been overdue. The logic is simple and experience confirms it: the longer a customer goes without paying, the higher the chance that the customer will never pay. A debt that is thirty days old is collected almost always; a debt that is two hundred days old almost never. That is why the business policy usually assigns a higher provision percentage to the older debts, for example, a low provision for debts under ninety days and growing percentages for the following ranges. These percentages are an internal decision of each business, based on its own collection history, and they should not be confused with tax rates or with legal requirements.

Let us see the complete example. Suppose that at the end of the month the receivables of your business add up to $8,000,000, distributed like this: $5,000,000 in debts up to sixty days old, $2,000,000 in debts around one hundred and twenty days old, and $1,000,000 in debts over two hundred days old. The internal provisioning policy, built from the collection experience of previous years, says that the business should provide five percent of the debts up to sixty days old, twenty percent of the debts around one hundred and twenty days old, and fifty percent of the debts over two hundred days old. The calculation looks like this.

The total provision for the month is $1,150,000. Check the math: five percent of five million is two hundred and fifty thousand; twenty percent of two million is four hundred thousand; fifty percent of one million is five hundred thousand; and the sum of the three is one million one hundred and fifty thousand. That is the amount that the business estimates it will not be able to collect, and that is why it must recognize it today as an expense.

The journal entry is the following.

The debit goes to an expense, which reduces the profit of the period by $1,150,000. That is the cost of selling on credit: a part of what was sold, it is estimated, will never be collected. The credit goes to the provision for doubtful receivables, an account that in the balance sheet is subtracted from the receivables. In this way the financial statements show the gross receivables of $8,000,000, the provision of $1,150,000 and a net balance of $6,850,000, which is what the business really expects to receive. The receivables stop being presented at their face value and are presented at their realistic value.

The customer pays later: reversing the provision

Making a provision does not mean declaring the debt lost. It means recognizing that a risk exists, and risks sometimes do not materialize. If the customer with the sixty-day debt pays, the business receives its $5,000,000 and the loss that had been estimated did not happen. At that moment the related provision, $250,000, must be reversed: the provision for doubtful receivables is debited and the provision expense is credited. The effect is that the expense of that month is canceled and the profit of the current month recovers.

That reversal mechanism is what keeps the principle of prudence from punishing the business twice. The provision was recognized when the doubt existed; if the doubt is resolved in favor of the business, the record is undone. If the customer pays only half, the proportional part is reversed. If the customer pays after the debt was written off, the money that comes in is not compared with any provision: it is simply recorded as a recovery of written-off receivables, an income for the business.

When the loss is confirmed: writing off the receivable

There comes a moment when there is no reasonable doubt left: the customer went bankrupt, disappeared, or the debt has been overdue for so long that collecting it is impossible. The receivable is no longer an asset and must leave the books. That process is called writing off the receivable, and it is recorded in one of two ways depending on the path followed before.

If the debt was provisioned, the write-off does not touch any expense: the provision for doubtful receivables is debited for the written-off amount and the receivable of the customer is credited. The expense was already recognized when the provision was made, so the write-off only cleans the balance sheet: the receivable disappears and the provision that supported it disappears too. If the debt was not provisioned, because the business skipped the aging analysis or because the loss came as a surprise, the write-off is recorded by debiting an expense directly and crediting the receivable. In that case the expense is recognized late, but it is recognized: the books cannot keep showing as collectible a debt that is not.

It is worth clarifying that writing off a debt does not mean giving up on collecting it. The write-off is an accounting fact: the debt leaves the assets because it no longer meets the conditions to stay there. The collection effort can continue outside the books, and if the customer pays someday, that money is recorded as a recovery. It also does not mean that the business forgives the debt of the customer; the commercial matter and the accounting matter are different and it is better not to mix them.

Inventory obsolescence and impairment: the same principle applied to goods

The logic of provisions is not limited to receivables. The business also buys merchandise expecting to sell it, and that merchandise can lose value before it is sold. One product gets damaged, another expires, another goes out of fashion and another stops being ordered because the market changed. When that happens, the inventory is worth less than it cost, and keeping it in the books at its original cost would overstate the asset, exactly the same way as ignoring an uncollectible debt does.

The principle is the same as with receivables: merchandise must be presented at its recoverable value, that is, at what the business can really obtain from it, and not at its cost, if that cost is no longer going to be recovered. If the recoverable value has fallen below the cost, the difference is recognized as an impairment expense, with an entry that debits that expense and credits the inventory or a provision for inventory impairment. If later the merchandise is sold or recovers value, the provision is reversed or adjusted, exactly as happens with receivables.

This lesson will not go deep into the calculation methods for impairment because the blog already dedicated a complete lesson to that topic [255], and the detail of the end-of-period adjustments was covered in the adjusting entries lesson of the accounting cycle (L10). What matters here is seeing the whole picture: the provision for doubtful receivables and the inventory impairment are two sides of the same principle, the principle that assets are presented at their realistic value and that probable losses are recognized when they become known.

Common mistakes when handling provisions

In practice, problems with provisions almost never come from the technique of the entry, which is simple, but from the decision to use it or not. These are the most frequent mistakes.

• Not making the provision so that profit looks high, that is, dressing up the receivables. It is tempting: if the expense is not recorded, the profit of the month looks better and the owner can feel at ease. But an uncollectible debt does not disappear for not writing it down, and the day it is confirmed, the blow will arrive complete and all at once. Meanwhile the balance sheet will be overstated, and any decision made on that information, from asking for a loan to distributing profits, will have been based on a false number.
• Charging the write-off twice. When the debt was already provisioned, the expense was recognized at the moment of the provision. When the debt is written off, you only debit the provision and credit the receivable. If you also debit an expense, the same loss appears twice in the results and the profit is understated. The rule is simple: the loss is recognized only once.
• Confusing the provision with savings. A provision is not money set aside nor a reserve that can be drawn upon; it is an account that reduces the asset and the profit. Understanding that difference avoids surprises when the balance sheet is reviewed.
• Forgetting the inventory. There are businesses that are very careful with their receivables and never check whether their merchandise is still worth what the books say. Silent obsolescence is as dangerous as a late-paying customer.

A closing routine for provisions

To take these ideas into practice, turn the provision into a routine that repeats at every month-end closing. The process can be summarized in five steps.

1. Generate the receivables listing by customer and group it by age of the debt, from the most recent to the oldest.
2. Apply to each range the provision percentage defined in the business policy and calculate the total estimated loss.
3. Record the provision entry by comparing the current balance of the provision account with the estimated value, and adjust for the difference.
4. Review the inventory looking for damaged, expired or slow-moving products, and compare their recoverable value with their cost.
5. Reverse the provisions of the debts that were already collected and write off the ones confirmed as uncollectible, without duplicating expenses.

That five-step ritual, repeated month after month, keeps the balance sheet honest and stops surprises from piling up. It is the same spirit that runs through the Kardex Tauro accounting manual: every lesson delivers a tool so that you can make decisions based on numbers that tell the truth.

Lesson summary

• Making a provision means recognizing today an expense for a probable future loss, applying the principle of prudence.
• A provision is not money set aside: it is an account that reduces the asset and the profit.
• The provision for doubtful receivables is calculated with the aging analysis of the debts; the older the debt, the higher the percentage, according to the internal policy of the business.
• The provision entry debits an expense and credits the provision for doubtful receivables, which is subtracted from the receivables in the balance sheet.
• If the customer pays, the provision is reversed. If it is confirmed that the customer will not pay, the debt is written off by debiting the provision, without touching the expense again.
• Inventory follows the same principle: it is presented at its recoverable value and the difference with its cost is recognized as an impairment expense.
• The loss is recognized only once: making a provision and then writing off with another expense duplicates the same fact.