Principles of Accounting: Introduction to Bad Debts

• To understand the concept of Provision for Doubtful debts first we must look at Bad Debts
• As outlined during the discussion of the matching/accruals concept
• Most businesses conduct business on credit in addition to cash sales
• Typically with cash sales payment is received when the goods are sold
• With credit however, payment is received at a later date
• Thus far it has been taken for granted that payment will be received
• In reality, for a number of reasons, there is always the risk that some of the business’s debtor’s will not pay
• This is a normal business risk and such bad debts are a normal business expense
• They should be written against profit for the period in which they occur
• The bad debts must also be written off from the current assets figure (Debtors/Trade Receivables)

Reasons for bad debts

• The debtor is refusing to pay one or more invoices
• The debtor is refusing to pay part of an invoice
• The debtor can only pay part of the debt due to death or bankruptcy

Entries to record a bad debts

• The following entries must be made in the books as soon as a bad is considered:
  1. Dr Profit and Loss (This is shown as an expense in the Income Statement)
  2. Cr The Debtors Account
• This is done in the period in which the debt is considered to be bad,
• The debt cannot be written off retroactively on last year period
• The story does not end there
• It is obvious there is need for a mechanism that accounts for bad debts before they occur
• This is where the provision for doubtful debts come in

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