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Provision for Bad Debts

The provision for bad debts is also known as the Allowance for bad debts/doubtful accounts. The provision is an estimated sum of debtors’ debts that is unlikely to be paid. It is inevitable that some of the customers who have bought goods on credit will not be able to settle their debts in full, more so if a firm has a high volume of debtors.

Some debtors may just refuse to pay or simply disappear and become untraceable or the cost involved in recovering a debt may exceed the amount of the debt. Other debtors may be faced with bankruptcy. In order to ensure that an accurate figure of the debtors is presented on the financial statements, a provision in proportion to the total debt due is created in each accounting period.

The creation of a provision for bad debts does not in any way reduce the individual balances of the debtors’ accounts or the debtors control account. However, a change made to the balance in the provision account increases or decreases bad debt expense on the income statement. Expense items must be reported on the statement in the period they are incurred.

The chief purpose of the provision is to show the net realizable value of the debtors that is as realistic as possible on the balance sheet. On the balance sheet, the provision which is a credit balance account is shown on the current asset side of the balance sheet as a deduction of the debit debtors account balance. Failure to provide reasonably accurate provision has the same effect of not disclosing reliable information such as overstating profit and debtors closing balance to interested parties.

The provision for bad debts needs to be adjusted at the end of each accounting period as the total balance of debtors varies in each period. There are no methods of calculation to adopt to arrive at an amount for the provision. Past experience is a useful guide to calculate the next provision, but a new company without records will seek out other sources for guidance until their own past data are sufficiently available. The usual way to make an estimate for the amount of the provision is to use a percentage of the total debtors balance.

When the provision for bad debts is first made, the following accounting entries are needed for the provision.

Debit profit and loss account (with the amount of the provision)
Credit provision for bad debts account


Aging schedule

To make available a bad debt provision as accurate as possible, a company is likely to scrutinize individual debts to determine which will be bad debts by noting the length of time they have been owed as is well known that the longer a debt is owed the less likely it will be paid. It may also use past experience as a basis to calculate a percentage of the debts that will be bad. Some firms maintain an aging schedule to show the age of the debts are so as to decide on their collectivity.


Following is an aging schedule for debts:

Shows debts individually

Debtor Balance Age (days) of debts
1 to 30 31 to 60 61 to 90 91 to 120 Over 120







A Airco 5,000 3,000 2,000


B Baboo 4,000 2,500
1,500

C Cocoo 4,000
2,000
2,000
D Dow 4,000 1,500 2,500


E Emotio 2,000

1,000 1,000
F Forgotte 6,000 3,000 1,500 1,500

G Gibbo 2,000

1,500 500
H Heave 2,500

1,500
1,000
Others 27,900
9,000 6,400 5,000 4,500 3,000







Total 57,400 19,000 14,400 12,000 8,000 4,000
%
2 5 10 15 25
Doubtful doubts 4,500 380 720 1,200 1,200 1,000

The above table shows the amount of the provision ($4,500) that is to be made. The following are entries for the general journal and accounts needed for the provision.


The general journal

Date Particulars Folio Dr Cr



$ $
20XX



Dec 31 Profit and Loss

4,500

Provision for bad debts


4,500

(Provision for bad debts)



General Ledger

Provision for Bad Debts Account

Date Particulars Folio Amount
Date Particulars Folio Amount



$



$





20XX







Dec 31 Profit and Loss
4,500


Profit and Loss Account for the year ended 31 December, 20XX



$
Gross profit xxx
Less: Expenses:

Provision for bad debts 4,500


Balance Sheet as on 31 December, 20XX


$ $
Current Assets:

Debtors 57,400
Less: Provision for bad debts 4,500 52,900


Increasing understated provision

If the provision for bad debts is less than what should be provided for in the next accounting period, the provision account needs to be revised to remain accurate. For example, if $1,500 was provided for bad debts (3% of $50,000) in the previous period, this balance of $1,500 brought forward is understated if the debtors have increased to $70,000. Maintaining the same percentage, 3% of $70,000 is $2,100. An increase of $600 is needed.


The general journal

Date Particulars Folio Dr Cr



$ $
20XX



Dec 31 Profit and Loss

600

Provision for bad debts


600

(Increasing bad debts provision)



General Ledger

Provision for Bad Debts Account

Date Particulars Folio Amount
Date Particulars Folio Amount



$



$
20XX



20XX


Dec 31 Balance c/d
2,100

Jan 01 Balance b/d

1,500





Dec 31 Profit and Loss
600












2,100



2,100














20X1







Jan 01 Balance b/d
2,100


Profit and Loss Account for the year ended 31 December, 20XX



$
Gross profit xxx
Less: Expenses:

Increase in provision for bad debts 600


Balance Sheet as on 31 December, 20XX


$ $
Current Assets:

Debtors 70,000
Less: Provision for bad debts 2,100 67,900


Reducing overstated provision

Likewise, if the provision calculated to cover the bad debts in the previous period is more than what is to be provided in the following period, an amendment has to be made to the provision. For example, previous provision was $2,850 (3% of $95,000) and in the following period the debtors account balance has fallen to $80,000, 3% of which is $2,400 – a reduction of $450. The provision is to be revised downward by this amount.


The general journal

Date Particulars Folio Dr Cr



$ $
20XX



Dec 31 Provision for bad debts

450

Profit and Loss


450

(Reducing bad debts provision)



General Ledger

Provision for Bad Debts Account

Date Particulars Folio Amount
Date Particulars Folio Amount



$



$
20XX



20XX


Dec 31 Profit and Loss
450
Jan 01 Balance b/d
2,850
" Balance c/d
2,400
















2,850



2,850














20X1







Jan 01 Balance b/d
2,400


Profit and Loss Account for the year ended 31 December, 20XX



$
Gross profit xxx
Add: Reduction in provision for bad debts
450


Balance Sheet as on 31 December, 20XX


$ $
Current Assets:

Debtors 80,000
Less: Provision for bad debts 2,400 77,600



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Last Updated (Sunday, 31 October 2010 23:20)