BAD DEBTS AND PROVISION FOR BAD DEBTS
Writing off Bad Debts
A bad debt is a debt a business knows with certainty will not be collected. Once it is established
that a debt is bad, the account receivable (debtor) is closed off or written from the ledger.
Sometimes the debtor is only able to pay part of his debt. The unpaid balance on the account is
written off as bad.
Journal and Ledger entries to write off Bad Debts
Writing off bad debts means the creation of one expense account to hold all bad debts and
closing off the individual bad debtor’s account. At year end, the Bad Debts Account is closed off
to the Income Statement as an expense.
Debit: Bad Debts Account
Credit: Customer’s Account
Debit: Profit and Loss Account
Credit: Bad Debts Account
Provision for Bad and Doubtful Debts
In most businesses, it is very difficult to determine with reasonable certainty the amounts of
debts that will not be paid. However, firms know that the longer a debt goes unpaid the greater
the chance that it will be uncollectible. They recognize a category of debtors called doubtful
debtors. Doubtful debts are those which cannot be classified as bad, but which experience says
will probably go bad eventually.
The possibility of loss from doubtful debts requires an adjustment of the figures when the
Income Statement and Statement of Financial Position are being prepared. A Provision for
Doubtful Debts also called a Provision for Bad Debts is created and maintained over time.
NB: A Provision can be defined as profit set aside for any known expense, which cannot be
determined with accuracy.
Calculation of Provision Amount
The amount of doubtful debts to be provided for is determined largely through the past
experiences of the businessman and the accountant. Some firms simply apply a small percentage
to the total of accounts receivable after known bad debts are written off.
In an alternative but more acceptable method, a list comprised of debtors whose payments are
overdue for varying periods. After careful examination of the list of debtors with aging debts, a
decision is made to declare percentages for older debts.
Creation of Provision for Doubtful Debts
At some point in time, the firm will create its provision for doubtful debts. The accounting
entry for the creation of a provision for doubtful debts is:
Debit: Income Statement/Profit & Loss a/c
Credit: Provision for Doubtful Debts Account
At the end of the accounting period, the Provision for Doubtful Debts would have served two
purposes:
Reduce the profit for the period by providing for estimated loss
Reduce the asset of debtors on the Balance Sheet, since the provision is deducted from
the debtors in the Balance Sheet.
In this way, the accounts will be a true and fair representation of the profit expected and the
amount the business reasonably expects to collect from debtors.
Maintaining a provision for doubtful debts
Once a provision for doubtful debts has been established, it remains on the books and appears in
the Balance Sheet. In subsequent accounting periods the amount to be treated as doubtful debts
will vary. For example, the percentage to be applied is fixed but the debtors’ balances vary.
These amounts appear as the balance on the provision for doubtful debts each year. The double
entry needed to reflect the change from one year’s balance to the next are as follows:
1. When the provision is to be increased:
Debit: Income Statement or Profit and Loss a/c
Credit: Provision for Doubtful Debts
With the amount needed to increase the provision
2. When the provision is to be decreased:
Debit: Provision for Doubtful Debts
Credit: Profit and Loss a/c or Income Statement
With the amount needed to decrease the provision
Effect on the Profit and Loss Account
Both Bad Debts and increases in the Provision Account are subtracted from the gross
profit because they are considered expenses.
Decreases in the Provision Account are treated as additions to gross profit as they are
considered revenues.
Effect on the Balance Sheet
In the Balance Sheet, debtors after Bad Debts are shown. The annual balance on the
Provision for Doubtful Account (not the increase or decrease in the Provision) appears as
a deduction from debtors. This figure is called net debtors.
Bad Debts recovered
In some instances, payment is received after a debt has been written off as bad. This is
probably due to a change in the fortune of the bad debtor. The payment is credited to a
Bad Debts Recovered Account and not to the personal account of the debtor, since that
account was closed off some time in the past. The recovered debt is transferred to the
credit side of the Profit and Loss Account. The effect of this of this on the profit is to
recognise a realized gain.
From Trial Balance to Final Accounts
When a trial balance is drawn up any bad debts already written off will appear in the
debit column. If a Provision for Doubtful Debts Account has been created before, the
opening balance will appear on the credit side. Below the Trial Balance, a note may
require further write-off debts and additional information will indicate how to calculate
the new Provision for Doubtful Debts.
Conclusion
Writing off Bad Debts and providing for doubtful debts are important if the business is to
maintain the accuracy of its records and also meet the requirements of sound accounting
principles and concepts; that is, to prepare accounts that are ‘true and fair’. Occasionally
bad debts are recovered and must be accounted for as credit in the Profit and Loss
Account (revenue). Journal entries, ledger accounts and final accounts are all prepared in
writing off bad debts and prudently providing for doubtful debts.
