In financial accounting, credit sales create debtors (accounts receivable). Some debtors may fail to pay and the resulting loss is treated as bad debts. To apply prudence and to show debtors at their realisable value, businesses create a provision for doubtful debts—an estimate of the portion of debtors that may become bad in future. Provisions and reserves are also important because they affect the measurement of profit and the presentation of financial position.
Bad debts are those debts which have become definitely irrecoverable. Once it is confirmed that the amount will not be received, it must be written off.
Bad Debts A/c Dr.
To Debtors A/c
Effect:
Doubtful debts are debts where recovery is uncertain. The debtor has not yet become insolvent, but there is a risk of non-recovery.
Provision for doubtful debts is created because:
At year-end, the required provision is compared with existing provision:
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When a debt becomes definitely irrecoverable, it is written off by debiting Bad Debts A/c and crediting the debtor’s account (Bad Debts A/c Dr. To Debtors A/c). This reduces the amount receivable. Bad debts are then charged to Profit & Loss account as an expense, reducing net profit. In the balance sheet, debtors are shown after deducting the bad debts written off, so current assets are not overstated.
Provision for doubtful debts is created to cover expected losses from debtors whose recovery is uncertain. It follows the prudence concept by recognising probable losses in the current period, so profit is not overstated. It also ensures that debtors are shown at net realisable value in the balance sheet. Without provision, both profit and debtors may be reported higher than what is realistically recoverable.
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In financial accounting, credit sales create debtors (accounts receivable). Some debtors may fail to pay and the resulting loss is treated as bad debts. To apply prudence and to show debtors at their realisable value, businesses create a provision for doubtful debts—an estimate of the portion of debtors that may become bad in future. Provisions and reserves are also important because they affect the measurement of profit and the presentation of financial position.
Bad debts are those debts which have become definitely irrecoverable. Once it is confirmed that the amount will not be received, it must be written off.
Bad Debts A/c Dr.
To Debtors A/c
Effect:
Doubtful debts are debts where recovery is uncertain. The debtor has not yet become insolvent, but there is a risk of non-recovery.
Provision for doubtful debts is created because:
At year-end, the required provision is compared with existing provision:
Provision is usually calculated on debtors after deducting further bad debts (if any).
Example working format:
This ensures debtors are shown at realisable value.
Sometimes an amount previously written off as bad debt is recovered later (for example, debtor pays after settlement).
Bad debts recovered are treated as income in the year of recovery.
Entry (one common approach):
Cash/Bank A/c Dr.
To Bad Debts Recovered A/c
Then:
Bad Debts Recovered A/c Dr.
To Profit & Loss A/c
Important idea: Provision is created because the expense/loss relates to the current period, even if exact amount is not known. Reserve is created by retaining profits.
Created out of operating profits and generally available for dividend.
Created out of capital profits and generally not available for dividend.
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Bad debts are actual losses arising when a debtor fails to pay and the amount becomes definitely irrecoverable. They are written off by passing the entry: Bad Debts A/c Dr. To Debtors A/c. Bad debts are charged to Profit & Loss account as an expense, reducing net profit, and debtors reduce in balance sheet.
Provision for doubtful debts is an estimate of probable future losses from debtors whose recovery is uncertain. It is created as a charge against profit following the prudence concept to prevent overstatement of profit and debtors. If provision is created/increased, entry is: Profit & Loss A/c Dr. To Provision for Doubtful Debts A/c. If provision is reduced, excess is credited back: Provision for Doubtful Debts A/c Dr. To Profit & Loss A/c.
In the balance sheet, debtors are shown at realisable value: Sundry Debtors (Less: bad debts written off / further bad debts, Less: provision for doubtful debts) = Net debtors. This treatment ensures true profit and true financial position.