What it means
When you sell goods or services on credit, you record the sale as revenue and the unpaid amount as an account receivable on your balance sheet. However, business reality means a small percentage of customers will inevitably default due to insolvency or disputes.
Rather than waiting until you write off the invoice completely, accounting rules require you to anticipate these losses. By creating a bad debt provision, you match the potential loss to the period in which the original sale occurred.
This practice follows the accrual principle, which states that expenses should be recognised in the same period as the related revenues. It prevents your company from overstating its profits and gives managers a realistic view of the cash they can actually expect to collect.
In practice, businesses calculate this provision using historical averages, industry benchmarks, or an ageing report that categorises unpaid invoices by how long they are overdue. As invoices age past ninety or one hundred and twenty days, the likelihood of collection drops sharply, and the provision percentage increases accordingly.
When a specific debt is finally confirmed as uncollectible, it is written off directly against this previously established provision, leaving your current operating results unaffected. Imagine you lend money to friends and keep a mental note that one or two of them might forget to pay you back.
Instead of assuming you are fully rich, you mentally discount your total by a few dollars so you are never caught short.
In practice
Real-world examples
Example 1
A digital design agency with $50,000 in unpaid client invoices estimates that 5% will not be paid. It records a bad debt provision of $2,500 to reflect a realistic collection expectation. Its accountant adjusts the figure every quarter as the real collection experience emerges.
Example 2
A wholesale bakery selling goods to local cafes holds $20,000 in receivables. Following a local economic downturn, it increases its bad debt provision from 2% ($400) to 8% ($1,600) to cover potential defaults. The $1,200 increase reduces profit for the period, but it warns the owner to tighten credit terms.
Example 3
A commercial cleaning firm with $100,000 in outstanding corporate accounts reviews invoice ageing and sets aside $10,000 for accounts more than 90 days overdue, ensuring accurate financial reporting. The remaining accounts are current and need only a small general provision. The credit controller chases the old accounts weekly.
Think of it
Imagine you lend money to friends and keep a mental note that one or two of them might forget to pay you back. Instead of assuming you are fully rich, you mentally discount your total by a few pounds so you are never caught short.
Formula
Calculation
Estimated Bad Debt = Total Accounts Receivable x Estimated Percentage Uncollectible.
Worked example: your total accounts receivable are $100,000 and historical data shows that 3% of invoices are never paid. The calculation is $100,000 x 0.03 = $3,000. You record a bad debt provision of $3,000, reducing the net value of your receivables on the balance sheet to $97,000.
The ageing method applies a higher percentage to older invoices. With $60,000 current at 1% ($600), $20,000 at 31-60 days at 3% ($600), $12,000 at 61-90 days at 10% ($1,200) and $8,000 over 90 days at 25% ($2,000), the total is $100,000 of receivables and a provision of $600 + $600 + $1,200 + $2,000 = $4,400. Net receivables are $95,600.Case study
Seen in the real world
This is a fictional, illustrative scenario. BrightSpark Lighting, a mid-sized commercial supplier, finished the financial year with $500,000 in outstanding accounts receivable. Historically, the company experienced a low default rate from retail clients who closed unexpectedly or disputed charges. The finance manager reviewed the ageing report and noted that economic pressures might push defaults up on older invoices. To maintain compliance and provide a truthful picture to stakeholders, BrightSpark applied tiered percentages: $400,000 current at 1% ($4,000), $50,000 at 31-60 days at 4% ($2,000), $20,000 at 61-90 days at 15% ($3,000) and $30,000 over 90 days at 20% ($6,000).
The bad debt provision totalled $15,000. This adjustment reduced net receivables on the balance sheet to $485,000 and decreased net profit by the same $15,000 for that accounting period. Six months later, a specific client owing $4,000 entered liquidation and could not pay. Because BrightSpark had already anticipated this type of loss, it wrote off the $4,000 against the existing provision, leaving $11,000 for other risks. The monthly operating profit remained unaffected by the bankruptcy, proving the value of proactive financial planning.
Watch out
Common mistakes
- Waiting until a customer explicitly declares bankruptcy before acknowledging any loss on an invoice.
- Using a static percentage year after year without reviewing actual historical collection rates.
- Forgetting to reduce the bad debt provision when old debts are successfully collected or written off.
Questions
People also ask
Is a bad debt provision the same as writing off a debt?
No. A provision is an estimate of future losses based on probability. A write-off is the removal of a specific, confirmed uncollectible debt from your accounts.
Does creating a bad debt provision cost actual cash?
No, it is an accounting adjustment that reduces your reported profit and asset values. It does not involve any physical cash leaving your bank account.
How do I determine the right percentage to use?
You look at your company's historical collection data, industry averages, and the current economic climate, applying higher percentages to older invoices.