Bad debt provisions are standard in business accounting. Your accounts receivable shows how much your customers owe. The bad debt provision reduces your accounts receivable to allow for customers who don't pay up. That gives you a more realistic picture of your business's income than assuming every receivable will be paid in full. The bad debt provision may affect your cash flow statement but it isn't one of the items the cash flow statement records.
The Cash Flow Statement
Your company's income statement and cash flow statement both show how your business performed in a given period. The income statement shows revenue and expenses. When you complete a sale, you include the revenue on the income statement even if you haven't been paid. Your cash flow statement doesn't include the revenue until you receive the money. The difference is important. If customers don't pay promptly, you can have great income but lack the cash you need to pay the bills.
The cash flow statement includes three sections. One deals with cash from investments, one with cash you receive from financing and one with cash from operations. That third category refers to money brought in by your regular business operations, whether that's running a car wash, selling computers or publishing ebooks. Operations are the most important entry because it shows how successful your business is at its regular money-making activities.
Calculating Cash Flow
There are two methods of drawing up a cash flow statement, direct and indirect. The organizations that set rules for accounting tend to favor the direct approach, but most businesses use the indirect method.
Suppose you're preparing your cash flow statement for the previous quarter. Using the direct method, you add up all the cash you've received from operations. Then you write down the amounts you've paid your suppliers and your employees for the same period. Subtract the payouts from the money paid in and you have your operational cash flow.
The bad debt provision isn't an issue with the direct method. You don't care about accounts receivable, only about money actually received. The income statement considers bad debt as an expense; the cash flow statement doesn't.
The indirect method starts with net income for the quarter. Then you subtract or add parts of the income statement that don't involve cash. Say your income for the quarter is $125,000. You increased accounts receivable by $36,000 in that period, accounts payable went up $16,000 and you added $3,000 to your bad debt allowance. Those items affect income, but not cash so you subtract $36,000 from $125,000, then add $16,000 and $3,000. You end up with $108,000 cash. Then you make any other adjustments necessary, for example, to cover depreciation.
The finance and investment parts of the cash flow statement stay the same either way.
- Inc.: Cash Flow Statement
- Accounting Tools: How to Prepare a Cash Flow Statement
- Accounting Coach: What is the difference between the direct method and the indirect method for the statement of cash flows?
- Financial Accounting Standards Board. "Summary of Statement No. 95." Accessed July 22, 2020.
- Financial Accounting Standards Board. "Statement of Financial Accounting Standards No. 95," Pages 7-11. Accessed July 22, 2020.
- Financial Accounting Standards Board. "Statement of Financial Accounting Standards No. 95," Pages 7-9. Accessed July 22, 2020.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com