Accounting Treatment for Provisions

The Concept of Provisions

A provision is an amount set aside out of profits to cover a known liability or an expected loss whose exact amount is uncertain but can be reasonably estimated. The key idea is that a business must account for probable future losses in the same period when the related revenue was earned — this is the matching principle in action. Without creating provisions, the profit shown would be overstated and the balance sheet would not present a true and fair view.

Types of Debtors

When a business sells goods on credit, it creates debtors. Based on the likelihood of collection, debtors fall into three categories:

• Good Debtors — Those from whom collection is certain. No loss is expected.
• Bad Debts — Those from whom recovery is impossible. The amount is a definite loss and must be written off immediately.
• Doubtful Debts — Those who may pay, but the business is not sure about collecting the full amount. Based on past experience, a certain percentage of such debtors is likely to default.

The Need for Provision for Doubtful Debts

Since some debtors may not pay in full, a business must anticipate this possible loss at the time of ascertaining true profit or loss. Creating a provision for doubtful debts is both a common practice and a necessity for accurate financial reporting. This provision is also called Provision for Bad and Doubtful Debts.

How to Calculate the Provision

The provision for doubtful debts is calculated as a certain percentage of the total amount due from sundry debtors after writing off all known bad debts. The steps are:

1. First, write off all actual bad debts from the sundry debtors balance.
2. Then, apply the required percentage to the remaining debtors figure.

Accounting Treatment

The accounting treatment for all types of provisions is almost identical. The provision is created by:

• Debiting the Profit and Loss Account with the amount of required provision
• Crediting the Provision for Doubtful Debts Account

The journal entry is:

Worked Example

From the books of Trehan Traders on March 31, 2014:

Extract of Trial Balance

Additional Information

• Bad debts proved bad but not recorded: ₹ 8,000
• Provision is to be maintained at 10% of debtors

Step 1: Write off the known bad debts

First, the actual bad debts of ₹ 8,000 must be written off from the sundry debtors.

Step 2: Transfer bad debts to Profit and Loss Account

Step 3: Create the provision for doubtful debts

Working Note:

• Sundry Debtors after writing off bad debts = ₹ 68,000 − ₹ 8,000 = ₹ 60,000
• Provision @ 10% = 10% of ₹ 60,000 = ₹ 6,000