Cambrige Notes: Principles of Accounting: Introduction to Provision for Doubtful Debts

• As we have pointed out in our examination of bad debts the story does not end there
• In our discussion of bad debts we stated that bad debts are only written of in the period in which they occur
• Sometimes this happens many periods after the sale was made
• Prudence dictates that losses be written off as soon as their existence is known
• Similarly the matching concept requires that we match revenue against all costs incurred in generating that revenue
• There is always the risk that a portion of our current sales will become bad debts in the future
• Using its knowledge and mathematical fourmulae a business can try to estimate the portion of its current debts that are likely to become bad in the future
• This estimate is known sometimes known as Provision for Bad Debts
• While this spells out the logic and rationale for this estimate it creates a problem
• Businesses are not clairvoyant charlatans who can gaze into a crystal ball and tell what will happen in the future
• Just because we think a debt will go in future does not mean it will
• Some of the suspect debtors will turn out to be alright and pay their debts in time
• So a more apt description would be Provision for Doubtful Debts
• There is probable doubt that this portion of debts might become bad
• Hence the phrase “doubtful debts”, the provision is a numerical estimation of our doubts

Calculating Provision for Doubtful Debts

• It is entirely up to the business and it policies how to provide for doubtful debts
• Some businesses come up with an absolute figure to be considered a provision for doubtful debts
• Most likely and for practical purposes the provision for doubtful debts is expressed as a percentage of debtors
• When given as percentage the provision should be applied to the business’s outstanding debtors after debts that are known to be bad have been written off
•  It would make little sense to calculate a provision on debts that we already know to be bad!
• Each year/trading period the provision is calculated on the total Accounts receivable (Debtors) as it stands during that period
• To be clear the provision is calculated on both the current period’s debts/accounts receivable as well as an outstanding amounts from previous periods
• It is not just applied on debts incurred in the current period
• There is the danger therefore that the business will end up charging a provision on the same debt twice
• To account for and prevent this Provision for Doubtful Debts makes use of cunning account entries

Accounting Treatment of Provision for Doubtful Debts

• During the first year the provision for doubtful debts is established
• Once the amount is known the following entries are made in the books:
  1. Dr Profit and Loss Account (Shown as an expense in the Income Statement) with the full amount of the provision
  2. Cr Provision for Doubtful Debts with the entire amount
• In subsequent years the amount for Provision for Doubtful Debts in the current period is calculated
• This amount is then compared to the one obtained in the previous period to determine if there is an increase or decrease
• If the amount in the current period compared to the last period it is deemed an increase and the following entries are used to record this:
  1. Dr Profit and Loss Account (Shown as an expense in the Income Statement) with the increase and the increase only
  2. Cr the Provision for Doubtful Debts with the increase and the increase only
• If the amount in the current period is less compared to one obtained in the last period this is deemed to be a decrease and the following entries need to be made:
  1. Dr Provision for Doubtful Debts with the amount of the decrease and the amount of the decrease only
  2. Cr Profit and Loss Account (Shown as an income in the Income Statement)
• When it comes to the Statement of Financial Position the entire amount of the provision for each period is deducted from the Debtors (Accounts Receivable) figure shown
• Since the Statement of Financial Position is a report that is not part of double entry this treatment has no effect on the debtors’s figure in subsequent years
• The accounting treatment of Provision for Doubtful Debts must not be confused with that for Bad Debts
• Nor is it the same with the treatment of Depreciation
• Keep this in mind or fail

To access more topics go to the Principles of Accounting Notes.