When somebody owes money but is unable to pay, the debt is a bad one. As soon as debts are known to be bad, they should be cleared from the sales ledger by transferring them by journal entry to a Bad Debts account.
Provision for Doubtful debts:
Although a debt may not actually have become bad, there may be doubt as to whether it will be paid; it may eventually turn out to be a bad debt. It would be misleading to include that debt as an asset in the Balance Sheet pretending that the amount is not in doubt. On the other hand, since it has not yet become bad, it would be wrong to write it off. A provision is made to cover that and other doubtful debts.
How to create and maintain a provision for doubtful debts:
When the provision is first created, debit the Profit and Loss Account and credit a Provision for Doubtful Debts account with the full amount of the provision.
In the years that follow, the entries in the accounts will be for increases or decreases in the amounts required for the provision:
“In subsequent increase in the provision: Debit the Profit and Loss Account and credit the Provision.”
“In subsequent decrease in the Provision: Debit the Provision for Doubtful Debts and credit the Profit and Loss Account.”
The Provision for Doubtful Debts is deducted from debtors in the Balance Sheet.
The following information is extracted from Jonah’s accounts:
At 31st December 2014, Jonah’s business has receivables from all the debtors amounting to $12,000 and the doubtful debts were $900. For the year ended December 31, 2015 & 2016, total receivables were $14,000 & $12,000 respectively while the doubtful debts amounted to $1,100 & $800 in respective years.
Jonah had not previously made a provision for doubtful debts. In the profit and loss account for years ended December 31, 2014, 2015 & 2016, Jonah shall recognize Provision for Doubtful Debts amounting to $900 (Dr.), $200 (Cr.) and $300 (Cr.) respectively.
How to calculate the amount of a provision for doubtful debts:
The calculation of a provision for doubtful debts depends on the type of provision required. There are three kinds of provision:
• Specific and general
Specific: Certain debts are selected from the sales ledger as doubtful. The provision will be equal to the total of those debts.
General: The provision is calculated as a percentage of the total debtors. The average percentage of debts by amount that prove to be bad is usually taken of this purpose.
Specific and general: The provision is made up of the debts that are thought to be doubtful plus a percentage of the remainder.
Provision for doubtful debts and the accounting concepts:
A provision for doubtful debts complies with the following accounting concepts:
Prudence: Amounts expected to be received from debtors should not be overstated in Balance Sheets. The Profit and Loss Account should provide for the loss of revenue and not overstate profit.
Matching: A possible loss of revenue should be provided for in the period in which the revenue was earned, not in a later period when the debt becomes bad.
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