Provision for Bad and Doubtful Debts

Provision for Bad and Doubtful Debts

When a business sells goods on credit, it creates debtors. Not all debtors will pay the full amount they owe. Some may default partially or completely. The exact amount that will turn into a loss is unknown at the time of preparing the financial statements. Accountants solve this by making a reasonable estimate of the likely loss and creating a provision for it.

This estimated loss is called provision for doubtful debts. It is an expense for the current year because the sales that gave rise to these debtors happened in the current year. The matching principle requires that the expense of potential bad debts be recognised in the same period as the revenue from those sales.

Accounting Treatment

The provision is created by debiting the Profit and Loss Account and crediting the Provision for Doubtful Debts Account. The journal entry is:

In the Balance Sheet, the provision is shown as a deduction from Sundry Debtors on the assets side. This gives the net realisable value of debtors.

Worked Example from the Book

Ankit has debtors of ₹13,000 on March 31, 2017. He estimates that 5% of these debtors (₹650) are likely to default. The adjustment entry is:

This ₹650 reduces the current year's profit. In the Balance Sheet, debtors of ₹13,000 are shown less the provision of ₹650, appearing at ₹12,350.

Treatment When an Old Provision Already Exists

The provision created at the end of one year is carried forward to the next year. This brought-forward provision is called the old provision or opening provision. During the next year, actual bad debts that occur are first adjusted against this old provision. At the end of the year, a new provision is calculated on the remaining debtors.

The steps are:

1. Write off any further bad debts from debtors (debit Bad Debts A/c, credit Sundry Debtors A/c).
2. Transfer the total bad debts (including any given in the trial balance and the further bad debts) to the Provision for Doubtful Debts A/c (debit Provision for Doubtful Debts A/c, credit Bad Debts A/c).
3. Calculate the new provision required on the remaining debtors.
4. Compare the new provision with the balance remaining in the Provision for Doubtful Debts A/c after step 2.
   • If the new provision is more, debit the difference to Profit and Loss A/c and credit Provision for Doubtful Debts A/c.
   • If the new provision is less, debit Provision for Doubtful Debts A/c and credit Profit and Loss A/c (reducing the charge).

Illustrated Example

An extract from a trial balance on March 31, 2017:

Additional Information: Write off further bad debts ₹1,000 and create a provision for doubtful debts @ 5% on debtors.

Step 1: Record further bad debts

Step 2: Transfer total bad debts to Provision account

Total bad debts = ₹2,000 (given in trial balance) + ₹1,000 (further) = ₹3,000

Step 3: Calculate new provision

Debtors after further bad debts = ₹32,000 − ₹1,000 = ₹31,000

New provision = 5% of ₹31,000 = ₹1,550

Step 4: Determine the amount to be charged to Profit and Loss

Balance in Provision for Doubtful Debts A/c after step 2:

• Old provision (credit balance): ₹3,500
• Less: Bad debts adjusted (debit): ₹3,000
• Balance remaining: ₹500 (credit)

New provision required: ₹1,550

Additional amount needed = ₹1,550 − ₹500 = ₹1,050

Journal entry:

Presentation in Final Accounts

Profit and Loss Account (extract) for the year ended March 31, 2017 …