How to Set Your Bad Debt Provision Using a Provision Matrix

Most SMEs set their bad debt provision by picking out a few customers who look shaky and writing off a round number. If you report under IFRS 9 in the GCC or Ind AS 109 in India, that is usually not enough. A provision matrix gives you a method you can repeat each quarter, explain to your auditor and defend at year end.

What the standards ask for

For ordinary trade receivables, IFRS 9 uses what is called the simplified approach. As BDO explains, it is mandatory for trade receivables and contract assets with no significant financing component, which usually means balances due within a year. Under it, you always recognise lifetime expected credit losses rather than working through the three-stage model banks use.

Two points catch people out. First, the provision covers receivables that are not yet overdue, not just the old ones. Second, your loss rates must reflect both what happened in the past and what you expect to happen next. BDO describes the model as a "forward looking expected loss model."

India follows the same logic. EY India notes that under Ind AS 109 the simplified approach requires a loss allowance based on lifetime expected credit losses at each reporting date, and that a provision matrix is given as a practical expedient. The standard does not tell you exactly how to build one, so the method below is a sensible, commonly used way to do it.

How to build a provision matrix in five steps

The steps below follow the approach set out by Deloitte Cyprus on Mondaq.

1. Group your customers. Put together customers with similar credit risk. Common groupings are by country, customer type (government, corporate, retail), product line, or whether a balance is covered by credit insurance or a guarantee. Keep it simple: three or four groups is plenty for most SMEs.

2. Choose a history period. Pick a period long enough to be reliable but not so long that it no longer reflects your business. The Deloitte article suggests something in the range of two to five years.

3. Work out historical loss rates by ageing band. For each group, look at how balances moved through your ageing buckets and how much in each bucket was never collected. The result is a loss rate per band, rising as balances get older.

4. Adjust for what you expect next. Historical rates describe the past. If conditions are changing, for example a key sector is slowing or a large customer group is paying later, adjust the rates up or down and write down why.

5. Apply the rates. Multiply each ageing band's balance by its adjusted rate and add up the results. That total is your provision. Use the same groupings you used to calculate the rates.

A worked example

For example, take a hypothetical Doha trading company with QAR 4,000,000 of trade receivables at year end, all in one customer group.

Now suppose the finance team expects slower payments in its main sector next year and decides, with reasons on file, to raise the rates by 10%. The provision becomes QAR 166,650.

Notice that QAR 11,000 sits against balances that are not even overdue. That is the part most old-style provisions miss entirely.

Separately, any customer you know is in real trouble, such as one in liquidation or one that has stopped responding, should be assessed on its own rather than left in the matrix.

What this means for your business

In Qatar and the wider GCC, if you report under IFRS, your auditor will expect a documented expected credit loss method. A matrix built from your own ageing data is far easier to defend than a judgement call made in the last week of the audit.

In India, companies that report under Ind AS face the same requirement under Ind AS 109. If your company is not on Ind AS, the matrix is still a sound way to size a provision honestly.

For your lenders and owners, a provision that moves with your ageing gives a truer picture of working capital. It also shows early if collections are slipping, because the provision will rise before the write-offs arrive.

Tax treatment of provisions differs between countries and between general and specific provisions, so check with your adviser before assuming any of it is deductible.

Your year-end checklist

• Pull an aged receivables report at the reporting date and check it ties to the ledger.
• Decide your customer groups and write them down.
• Gather two to five years of collection history by ageing band.
• Calculate a loss rate for each band in each group.
• Agree any forward-looking adjustment and record the reasons.
• Take out known problem customers and assess them one by one.
• Apply the rates, book the movement, and keep the workings for your auditor.
• Repeat at least quarterly, using the same method, so the year-end number holds no surprises.

If your ageing and collections data sit in one place, this becomes a short monthly routine rather than a year-end scramble. NexCFO's AR collections and MIS reporting are built to keep that data current.

A clear, repeatable method beats a round number every time.