Bad Debts and Provision for Bad Debts

Introduction

Once a business decides to offer its goods and/or services on credit to its customers that business has to be prepared for some of its customers not paying for the goods and/or services they received. When this occurs the necessary adjustment should be made to account for these unpaid debts. In accounting when a business is unable to collect the amount due from its customers the amounts owed should be transferred to a bad debts account. In this topic you will look at bad debts and provisions that should be made for bad debts in your business.

Objectives

Upon the completion of this topic you should be able to:
1. identify a bad debt;
2. describe how bad debts are written off;
3. explain how provisions for bad debts are made;
4. make accounting entries,
(a) to recorded bad debts and provision for bad debts,
(b) for increasing and reducing the provision for bad debts, and
(c) for bad debts recovered.

Bad Debts

When a business decides to sell its goods/services to customers for credit there is a possibility of some of these customers not paying for the goods/services received. A customer may not be able to pay because their business has suffered a loss or they may have gone bankrupt. Bad debt is an expense to your business. Bad Debt is a debt that is unlikely to be paid.

Examine the following example.

Example 3.4 A You sold goods on credit to M. Label for $500 on the 21 January 2011. On March 15, you sold $725 goods on credit to J. Jackets. On the 1st June you received $375 by cash from M Label and on the 30 August you received $650 by cheque from J Jackets. At the end of your financial year you were notified that both M Label and J Jacket would not be able to pay the balance of their debts. You then decide to write the debts off.

The following accounting entries are required:

Debit - Bad Debt Account - to transfer the amount of the unpaid debit.
Credit - Debtors Account - to reduce the liability for the debtor who is unable to pay.

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Debit - Profit & loss Account - to record the amount of bad debt for the accounting period.

Credit - Bad Debt Account - to transfer the amount of bad debt to the profit and loss account. 

Your accounts should be as follows:

M. Label
Date	Details	Folio	Amount	Date	Details	Folio	Amount
2011			$	2011			$
21-Jan	Sales	GL	500	01-Jun	Cash	CB	375
				31-Dec	Bad Debts Account	GL	125
			500				500
J Jacket
Date	Details	Folio	Amount	Date	Details	Folio	Amount
2011			$	2011			$
15-Mar	Sales	GL	725	30-Aug	Bank	CB	650
				31-Dec	Bad Debts Account	GL	75
			725				725
Bad Debts Account
Date	Details	Folio	Amount	Date	Details	Folio	Amount
2011			$	2011			$
31-Dec	M. Label	SL	125	31-Dec	Profit & loss	a/c	200
31-Dec	J. Jacket	SL	75
			200				200

Profit & loss (extract) for year ended 31 December 2011
			$	$
Gross Profit				xxxx
Less Expenses
Bad Debts				200

Provision for Bad Debts

Because your business sell goods to its customers on credit you should make provision for the likelihood that some of customers will not pay their debt in full. A provision for bad debts account is created to show the estimated amount of debts that your business may not be able to recover. The amount for provision for bad debts can beestimated as follows

• By looking at each debt and estimate which one will be bad
• On the basis of experience estimate what percentage of the debts will result in bad debts

Normally a business decides what percentage of its debtors at the end of financial year it would estimate as being unrecoverable. Once the percentage is decide then the accounting entries are required
In the first year:

• Debit - Profit & loss Account with the amount of the provision
• Credit - Provision for Bad Debts Account

Increase in Provision of Bad Debts Amount
In the years that follows if the amount of the provision is greater than the year before then the difference between both years is recorded as follows

• Debit - Profit & loss Account (with the difference between previous and present year)
• Credit - Provision for Bad Debts (with the difference between the previous and present year)

Decrease in Provision of Bad Debts Amounts
If the amount of the provision is less than the previous year the entries would be
Debit - Provision for Bad Debts (with the difference between the previous & present year)
Credit - Profit & loss Account (with the difference between previous and present year)

Example 3.4 B A business estimates that 2% of its debtors at the end of each year will be bad debts. The debtors figure for that business for the years 2011 – 2013 are: 2011 Debtors $ 10,000 2012 Debtors $ 12,000 2013 Debtors $ 8,000 Show the accounting entries necessary to record the above.

The calculation is shown in the table below:

Debtors	Provision Percentage	Provision Amount	Profit & Loss
	$	%	$	$
2011	10,000	2	200	200
2012	12,000	2	240	40
2013	8,000	2	160	80

You can now show the accounting entries to record these calculations

Provision for Bad Debts Account
Date	Details	Folio	Amount	Date	Details	Folio	Amount
2011			$	2011			$
31-Dec	Balance	c/d	200	31-Dec	Profit & Loss	a/c	200
2012				2012
31-Dec	Balance	c/d	240	1-Jan	Balance	b/d	200
				31-Dec	Profit & Loss	a/c	40
			240				240
2013				2013
31-Dec	Profit & Loss	a/c	80	1-Jan	Balance	b/d	240
31-Dec	Balance	c/d	160
			240				240
				2014
				1-Jan	Balance	b/d	160

Profit & loss (extract) for year ended 31 December 2011 - 2013
		$			$
2011	Provision for Bad Debts	200
2012	Provision for Bad Debts	40
			2013	Provision for Bad Debts	80

Balance Sheet (extract) as at 31 December 2011 - 2013
		$	$
2011	Debtors	10,000
	Less Provision for bad debts	200	9,800
2012	Debtors	12,000
	Less Provision for bad debts	240	11,760
2011	Debtors	8,000
	Less Provision for bad debts	160	7,840

Take note that a reduction in the provision for bad debts is revenue to your business and should be added to your gross profit. Also note that the balance on the provision for bad debts account at the end of each financial period is subtracted from the debtors figure in the balance sheet.

Let now look at fully worked example:
Example 3.4 C
A business started on 1 January 2005 and its financial year end is 31 December annually. The table of the debtors, the bad debts written off and the estimated provision for bad debts at the end of the year is: 

Debtors	Bad Debts written off	Provision for Bad Debts Amount
	$	$	$
2005	12,000	298	100
2006	15,000	386	130
2007	14,000	344	115
2008	18,000	477	150

You are required to show the bad debts account and the provision for bad debts account, as well as the extracts from the Profit & loss account for each year and the balance sheet extracts.


The double entry records to show the above is as follows

	Provision for Bad Debts
Date	Details	Folio	Amount	Date	Details	Folio	Amount
2005			$	2005			$
31-Dec	Balance	c/d	100	31-Dec	Profit & loss	a/c	100
2006				2006
31-Dec	Balance	c/d	130	1-Jan	Balance	b/d	100
				31-Dec	Profit & loss	a/c	30
			130				130
2007				2007
31-Dec	Profit & loss	a/c	15	1-Jan	Balance	b/d	130
31-Dec	Balance	c/d	115
			130				130
2008				2008
31-Dec	Balance	c/d	150	1-Jan	Balance	b/d	115
				31-Dec	Profit & loss	a/c	35
			150				150
2009				2009
				1-Jan	Balance	b/d	150

Profit & loss Account (extracts) for the year ended 31 December

			$	$
2005	Bad Debts	298
	Provision for Bad Debts	100
2006	Bad Debts	386
	Provision for Bad Debts	30
2007	Bad Debts	344	Reduction in Provision for Bad Debts	15
2008	Bad Debts	477
	Provision for Bad Debts	35

	Balance Sheet (extract) as at 31 December
		$	$
2005	Debtors	12,000
	Less Provision for Bad Debts	100	11,900
2006	Debtors	15,000
	Less Provision for Bad Debts	130	14,870
2007	Debtors	14,000
	Less Provision for Bad Debts	115	13,885
2008	Debtors	18,000
	Less Provision for Bad Debts	150	17,850

There are instances where bad debts that are written off are recovered in the future. When this occur the debt should be reinstate by:

• Debit - Debtors Account
• Credit - Bad Debts recovered Account

When cash or a cheque is received from the debtor in settlement of the account the entries should be:

• Debit - Cash Book
• Credit - Debtors Account

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Topic Summary

You just looked at the accounting entries required to bad debts and provision for bad debts. You should remember that after the first entry for provision for bad debts in the Profit & loss account the difference between the previous year and the present year is recorded in the Profit & loss account. Note that balance on the provision for bad debts account at the end of the financial period is deducted from the balance on the debtors account in the balance sheet. You should also remember that a reduction in the provision of bad debts is revenue to your business and should be added to your gross profit while an increase is an expense and should be deducted from your gross profit.