Provision for Doubtful Debts

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Concept and Definition of Provision for Doubtful Debts or Allowance for Bad Debts or Allowance for Un-Collectible Accounts:

Businesses usually create a provision for doubtful debt to provide for doubtful debts. “Provision for doubtful debts or allowance for bad debts or un-collectible accounts state the proportion of trade receivables that the business expects, but may not be recovered”.

Explanation:

The provision is supposed to show the likely size of the future bad debts. This is subtracted from the trade receivables figure on the balance sheet so as to give a more realistic figure for the amounts likely to be collected.

Types:

There are following two types of provision for doubtful debts or allowance for bad debts:

(1) General Provision for Doubtful Debts:

The term “general” is used when there is no clear evidence that which trade receivable will not clear his debt. This is usually expressed as a % of closing trade receivables and is usually estimated on the basis of past trend and future expectation about the receivables and other prevailing conditions.

(2) Specific Provision for Doubtful Debts:

The word “specific” means that there is clear documentary evidence like litigation and other findings that show that a particular trade receivable might turn bad (irrecoverable). The creation of this provision is based on appraising the the trade receivables on individual basis. The accounting treatment of a specific provision is the same as applied for the general provision.

Calculation:

The following factors are taken into account to calculate the provision for doubtful debts:

(a) Economic climate – frequency of business failure

(b) Past record of each trade receivable and the amounts of debts outstanding from each customer

(c) How long each debt has been outstanding

Accounting Treatment for Provisions in Financial Statements:

The effects of provision for doubtful debts in financial statements may be summed up as follows:

(1) Income Statement: Only change (increase or decrease) in provision for doubtful is shown in the income statement. When increase then expense (deducted from profit) and when decrease then income (added in profits).

(2) Balance Sheet: Total amount of provision at year end is deducted from trade receivables.

General Journal Entries – Provision for Doubtful Debts:

The procedure for the recording of the provision for doubtful debts is shown below:

Entry 1: Creation of provision for doubtful debts:

Debit (Dr) Income statement

Credit (Cr) Provision for doubtful debts

Entry 2: Recording increase in provision for doubtful debts:

Debit (Dr) Income statement

Credit (Cr) Provision for doubtful debts

Entry 3: Recording decrease in provision for doubtful debts:

Debit (Dr) Provision for doubtful debts

Credit (Cr) Income statement

Solved Example 1:

A business makes a provision of $3000, which was 2% of all his trade receivables, and a further expected loss of $1200, the total amount owed by one of its customers, Franklin, who had been declared bankrupt.

Required:

Determine the amount of general and specific provision for doubtful debts?

Solution:

General provision is $3000, whereas specific provision is $1200 and total provision for doubtful debts would be made at $4200.

Solved Example 2 – (Balance Sheet Extract):

Year 1: Assuming in year 1, we need to create a provision for doubtful debts @ 10% of trade receivables which were $800000. The original entry is:

provision for doubtful debts 1

Year 2: At the end of year 2, we have reviewed our trade receivables which were $900000 at that date and decided to make the provision again at the rate of 10% of trade receivables. This adjustment will increase the provision by $10000 [(900000 x 10%) – $80000]. It would be recorded as:

provision for doubtful debts 2

Year 3: At the end of year 3, we have again reviewed our receivables which were $720000 and provision was required to be at the rate of 10%. So it will decrease by $18000 [($720000 x 10%) – $90000]. It would be recorded as:

provision for doubtful debts 3

Required: 

Effects of provision for doubtful debts in financial statements or Relevant income statement and balance sheet extracts for three years.

Solution:

Effects in Income Statement:

For year 1: Profit is lowered by $80000

For year 2: Profit is lowered by $10000

For year 3: Profit is increased by $18000

So in three years, overall profit is lowered by $80000 + $10000 – $18000 = $72000

Effects in the Balance Sheets:

At the end of year 1:

provision of doubtful debts example 2 assets

At the end of year 2:

provision of doubtful debts example 2 assets for year 2

At the end of year 3:

provision of doubtful debts example 2 assets for year 3

The increase in provision for doubtful debts will reduce the profit and also reduce the value of the trade receivables in the balance sheet.

We can also see that at any point of time, the total amount of provision for doubtful debts is equal to the total net amount charged to the income statement right from the first year on account of change in provision for doubtful debts.