Doubtful Debts Provision: a Worked Example

Receivables are a promise from customers, and some customers break promises. The provision is the business's judgment of how many will, made at the balance date and charged against the year's profit. A lender cares about it twice. On the balance sheet it decides how much of the debtor ledger is real, which matters to an overdraft or invoice finance line sized against debtors. In the profit and loss account its movement sits inside operating costs, so a provision that shrinks while the ledger ages adds to EBITDA that no customer paid for.

The provision cannot be judged alone. Its meaning comes from the aged debtors report beside it: how much is current, how much is overdue, and by how long. A provision that is small against a young ledger is unremarkable; the same provision against a ledger with a long overdue tail asks a question.

What the provision is built from depends on the accounts. In accounts prepared under NZ IFRS 9 or AASB 9, the local texts of IFRS 9, trade receivables without a significant financing component carry an allowance for the losses expected over their whole life, and the standard permits a provision matrix as a practical way to estimate it: loss rates by age band, drawn from the business's own history and adjusted for conditions now. UK groups reporting under FRS 102 mostly apply its own impairment rules and provide when there is objective evidence that a loss has occurred, unless they have taken the standard's option to apply IFRS 9 instead; the 2024 periodic review did not bring the expected loss model into those rules. Accounts prepared mainly for tax and the bank, common among owner-managed businesses in all three markets, often provide only for named customers. In New Zealand and Australia part of the reason is tax: a bad debt is generally deductible only once it is both bad and written off, so a general provision earns no deduction.

A wholesaler of hairdressing and beauty supplies, constructed for this page like every figure in it, sells on account to about 900 salons. Its trade debtors are US$4.3m. Its provision is US$60,000, specific to two salons that closed; a year ago it was US$160,000, and no debts were written off in the year. EBITDA is US$2.1m and net debt US$6.0m. Over the last three years it has written off a steady share of each age band, which the lender uses as loss rates.

The wholesaler's ledger has aged while its provision fell. US$600,000 is more than ninety days old, and the business's own record says it collects about half of what passes 120 days. Of the US$219,000 between the two EBITDA figures, US$100,000 is the release that lifted this year's profit; the rest is the charge a matrix would have made. Rebuilt, earnings fall by about a tenth and leverage rises by a third of a turn. The loss rates are the example's, drawn from its own invented history, not a market norm.

Three entries reduce receivables, and a lender keeps them apart. A provision estimates a loss without giving up the debt; the gross amount is still pursued. A write-off removes a debt judged uncollectable, using any provision already made for it. A credit note reverses part of a sale, for returns, rebates, pricing errors or disputes. The last is the one most often missed: a ledger can carry invoices that customers do not intend to pay because they are waiting for a credit, and no provision covers them because they are not credit losses at all. A lender sees them as dilution, the gap between invoiced and collected, which is why it reads credit notes issued after the balance date and runs debtor verification on the largest balances.

The provision also differs from what a lender itself removes. A borrowing base commonly excludes debts beyond an agreed age altogether, whatever the provision says, so the borrower's estimate and the lender's eligible debtors answer different questions.

DEFINED IN ONE PARAGRAPH → · AGED DEBTORS REPORT → · CROSS-AGEING →

It decides the earnings a lender believes. A year in which EBITDA rose partly because the provision fell is a year whose improvement a lender discounts until it sees the cash collected. In a covenant test the effect is direct, as the example shows, and a borrower close to a leverage level has an incentive to be generous to itself at the year end. A lender that has the aged debtors report every month sees the tail grow before the accounts admit it.

It decides the facility too. Where the overdraft or an invoice finance line is sized on debtors, an understated provision means the lender is advancing against money that will not arrive. The response is not necessarily a smaller facility: a borrower that tightens credit terms, insures its larger accounts or provides properly against the tail gives the lender a ledger it can rely on, and the lender may then advance more against it, not less.

FINANCIAL REPORTING, READ BY A LENDER → · BORROWING BASE CERTIFICATE →