Write-off of receivables or when a company recognises that it can no longer collect a debt

Write-off of receivables as well as the creation of provisions for receivables enable companies as accounting tools to manage cash flows efficiently. By writing off receivables, a company can adjust its financial statements to the actual situation and thus reflect the financial health of the company. When writing off a receivable, the company recognises that it can no longer recover the receivable and recognises it as a definitive loss. We wrote about what an accounts receivable is and what all types of accounts receivable exist in a previous article. You can read it at the link provided.

What is a write-off of a receivable?

Receivable write-off is an accounting tool. When a company writes off a receivable, it means that it recognizes that the receivable no longer has a realistic chance of collection and therefore the company removes it from its books. A receivable written off can no longer be regarded as potential income, but is instead a definite loss. Through this step, the company will definitively cease to count on money that it would probably never have received anyway.

When can a receivable be written off?

Writing off a receivable is usually the last step a company takes when it has already tried debt collection and all available options. The moment the receivable is no longer recoverable, there is no choice but to write it off. This happens most often for the following reasons:

• The debtor has ceased to exist. This occurs when, for example, a natural person dies or a company is dissolved without liquidation.
• The debtor is insolvent or shows long-term signs of insolvency.
• The claim has exceeded the statutory limitation period. This means that the company can no longer legally enforce its payment.

As an accounting process, the write-off of the receivable is reflected in a loss in the value of the firm’s assets. Therefore, it has a potential negative impact on its profit and loss. Each company should therefore always carefully consider at what stage it will eventually proceed to write off a receivable.

What is an allowance for doubtful accounts?

Allowances for receivables are a kind of notional reserve. A company makes this provision in case some of its receivables are not paid by debtors. The allowance is used to allow the company to realistically assess its situation and recognise a possible loss on the receivables before the receivable is actually written off. Simply put, an allowance for doubtful accounts is a preliminary step before the actual write-off of the receivable. For example, a company may take a write-down on a bad debt that it is unlikely to collect.

Allowances give companies flexibility and allow them to report their receivables fairly in their financial statements. The creation of an allowance allows a firm to recognise potential losses over time, thereby ensuring that its accounting reflects actual financial reality rather than unrealistic expectations of recovering all receivables.

The creation of allowances for receivables is subject to accounting standards and tax regulations that determine when and how allowances can be created. This process is regulated in the Czech Republic by the Act on Provisions for Determining the Income Tax Base. It is also governed by accounting regulations and decrees.

Under what conditions is it possible to create a correction entry?

A company typically creates an allowance for receivables that are past due and for which it sees a real risk that the debtor will not repay the receivable. The specific criteria for creating an allowance are:

• Past due receivables: receivables that are longer past due have a higher risk that the debtor will not repay them. In general, the longer the receivable is past due, the higher the allowance should be.
• The financial situation of the debtor: If the debtor shows signs of financial difficulties, for example being insolvent or unable to pay its debts, an allowance is necessary.
• Amount of the claim: Higher-value claims may result in a higher loss in the event of uncollectability and therefore require more consistent provisioning, specifically through an allowance.

What types of allowance exist?

Allowances are divided into tax and non-tax. Tax provisions are deductible for income tax purposes. This means that a company is allowed to include them in its tax base, thereby reducing its tax liability. The conditions under which these provisions may be made are clearly defined in the Provisions Act. Under this law, for example, tax provisions can be made for receivables that are at least 18 months or more past due.

In contrast, non-tax provisions have no direct effect on the tax base. However, they serve to ensure that the financial statements reflect the true financial position of the company.

What is the difference between an allowance and a write-off of a receivable?

While an allowance serves to give the company a preliminary estimate of the possible loss on the receivable, so it is only a kind of theoretical protection, a write-down of a receivable is definitive and represents an acknowledgement that the receivable is no longer recoverable. The allowance is therefore an accounting provision that passes to the write-off of the receivable itself. If the receivable eventually becomes uncollectible, the firm can use this allowance to cover its loss.

Specific differences between an allowance and a write-down:

• Time: An allowance is created by a firm when a receivable is past due and there is a risk that the debtor will not pay it, but it is not yet clear that it is uncollectible. In contrast, a write-down of a receivable occurs only when it is certain that the receivable will not be paid.
• Accounting impact: An allowance is a provision that reduces the value of a receivable on the balance sheet, while a write-off of a receivable completely eliminates the receivable from the firm’s assets.
• Impact on the tax base: Tax provisions can reduce the tax base if they are made in accordance with the law, whereas the write-off of a receivable is a loss that affects the firm’s profit or loss.

Summary

Write-off of receivables and provisioning are accounting tools by which firms realistically assess the risk that a particular receivable will not be paid and recovered. The use of write-downs of receivables provides an accurate representation of the value of its assets because it recognises that a specific amount of the receivable is no longer receivable and is therefore a definite loss. When a company creates an allowance for receivables, it creates a reserve in case the receivable is ultimately not paid, allowing it to better plan and manage its finances.