What Is the Provision for Doubtful Debts and Bad Debts?

Even though a company that owes you cash needs to repay you by law, there is no guarantee that they will do it. There can be various reasons why you did not receive the payment, including bankruptcy and working capital issues. Your company needs to consider this issue in the financial statements. How do you go about that? You set aside money for doubtful debts. Let’s learn about this technique in detail.

Did you know? “Provision” is the term that a company uses to describe the extra amount set aside in an organisation's accounts to cover a known liability of uncertain timing or amount.

Provision for Doubtful Debts

Let us first look at the provision of doubtful debts meaning. The amount of bad debt to result from issued but uncollected accounts receivable is represented by the reserve for doubtful debts. It's the same as the provision for uncertain accounts. In accrual accounting, businesses use the provision to recognise an item of expenditure for potential bad debts. They do this as soon as bills are given to clients instead of waiting to determine which bills are unrecoverable. The net result is the acceleration of bad debt identification to set up the provision for doubtful debts.

Also Read: Meaning of Accountancy and How it Differs From Accounting

Accounting for the Provision for Doubtful Debts

The value of bad debt is often estimated by a business depending on past performance. This sum is charged to expenditure with a deduction to the bad debt expenditure accounts (which shows in the net income). It is also charged as a credit to the provision for doubtful debts account (displayed in the financial sheet). 

Making this entry during a similar period when the company bills the client will ensure that all necessary expenses and earnings match accordingly. Eventually, once it is known that a certain client will not pay the bill, remove it from the provision for doubtful debts. 

It could be accomplished with a general journal to two balance sheet accounts. It, therefore, does not affect the statement of income: debiting the provision for doubtful debts and crediting the accounts receivable. When employing an accounting system, you can generate a credit note resulting in a similar journal entry in the amount of the outstanding invoice.

Being an estimation, it is highly improbable that the provision for doubtful debts would always equal the number of outstanding bills. You will be required to gradually alter the balance in these accounts to make it more relevant to the current estimation of bad debts. When provision appears to be minimal, this may involve adding to the bad debt cost account or decreasing the expenditure (in case they find the allowance to be large).

Presentation of the Provision for Doubtful Debts 

The provision for doubtful debts is shown in the financial statements immediately underneath the part of the budget for receivable accounts. It is a counter account to accounts receivable. Therefore it must always have an outstanding balance. For statistical reasons, the company merges the two line items to provide a total receivables amount.

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How to Calculate the Provision for Bad and Doubtful Debts? 

Companies generally assess the level of bad debt depending on past performance. There are two ledger categories which a company uses to record the provision for bad debts in the accounting records.

• The provision for doubtful debt
• The provision for the doubtful debt – adjustment entry

The overall provision for accounts receivable, which the company may write off, is shown in the provision for doubtful debt, and any adjustments to this provision get recorded with the modification method for accounts. In the "loan" section of the accounts, you make necessary changes to the provision for doubtful debt. Nevertheless, you do that on the "debt" side if you require reducing or eliminating the allowance.

You must remove a bill from the provisions for bad debts whenever you come across one that is unlikely to get paid. You can make a journal entry that pays the accounts receivable account and deducts the provision for bad debts.

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How to Account For Provision for Doubtful Debts?

Here is an illustration of how the provision for doubtful debt on accounts receivable functions. Assuming that just at the year's closing, organisation A has a net of ₹2,00,000 in accounts receivable. Organisation A chooses to set aside 2% of the entire balance of receivables as a provision for bad debts. The provision for bad debts can be calculated as follows:

2,00,000 x 2% = ₹4,000.

One can record this in the company's accounting journal as follows:

Nevertheless, organisation A's entire accounts receivable even by the conclusion of the following year amount to ₹250,000. This indicates that there is a need for more money set aside for speculative debts. As a result, it increases the provision for doubtful debts by ₹5,000 (₹250000 multiplied by 2%). The amended allowance will appear as follows in your record-keeping:

What happens when it becomes necessary to enhance the provision for doubtful debts? Consider the scenario in which organisation A's entire accounts receivable are ₹2,25,000 by the close of the financial year. This calls for another adjustment to the provisions of bad debts. One can insert this modification journal entry as follows:

Also Read: What are Expenses in Accounting? Meaning & Types of Expenses in Accounting

What Is a Bad Debt Provision? 

A bad debt provision is a buffer against the potential future identification of some accounts receivable that could be unrecoverable. For instance, if a business has billed consumers for ₹10,00,000 in a specific timeframe and has seen a 1% bad debt rate, it’d be justifiable to set up a provision for bad debt of ₹10,000.

A company must balance earnings with associated costs in a similar accounting period, which is why a bad debt provision is necessary. By doing this, a company can display the impact of an invoiced selling transaction in a uniform accounting month. The expense could occur several months after the starting revenue identification associated with the invoicing. It’s possible if you choose not to use a bad debt provision but a direct write-off technique. This could be an instance if you only start charging bad debts to expenditure since you were sure that a particular invoice wasn’t recoverable.

Therefore, with the direct write-off technique, profit will be high throughout the client billing cycle, whereas excessively low when you eventually credit a part or the entirety of a bill to the bad debt.

Accounting for a Bad Debt Provision

A company makes a debit to the bad debt account and a credit to the bad debt provisions accounts to produce a bad debt allowance. The accounts receivable provision account has a value that is the opposite of the typical debit amount seen in the related account receivable because it is a trade receivable contra account.

Generate credit notes in the accounting system for the unrecoverable portion of a given bill whenever it's later confirmed to be such. The credit memo decreases the account receivables with credit and decreases the bad debt allowance accounts with a deduction. As a result, the original formation of the bad debt provision results in an expenditure. Although its eventual decrease against the receivables balance only affects the balance sheet's matching accounts and has no subsequent effect on the financial statements.

Documentation of Bad Debt Provision Adjustments

Your company should have a balance sheet to record a detailed view of the financial statement. It should include provisions for bad debt. This is because it is hard to predict exactly how many bad debts will arise from the present accounts receivable at a certain time in the future. Potential increases and declines in bad debt could result from various modifications. You should completely record the justifications for implementing the modifications because they can be interpreted as an attempt to manipulate a company's stated profitability.

Also Read: Understanding the Limitations of Accounting in Detail | Khatabook

Conclusion:

Provision for bad debts will have a massive effect on the firm's financial condition because of its immediate impact on the company’s profit and loss statement. As a result, anyone must do the estimation only using the firm's past performance.

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