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18. Bad Debts and Provisions

Bad Debts

It is a fact of ordinary business that not all 'Sundry Debtors' can be collected.  Some of the debts may never be collected because the debtors are either dead, bankrupt, cannot be traced, or are unable to pay.  The amount of debts that are definitely known to be irrecoverable must be written off as bad debts.  Bad debts are regarded as an expense in earning the revenue of that accounting period and must be debited to the Profit and Loss Account on Balance Day.

Provision for Bad and Doubtful Debts

The amount of debts which is definitely irrecoverable will be written off as bad debts during the accounting period when it is thought to be irrecoverable.  In addition to this, it is very likely that a certain amount of the total Sundry Debtors arising out of the current period's business activities may go bad.  But exactly how much of these debts is irrecoverable and from whom will only be known for sure in the subsequent accounting period.  So the firm must make a provision for debts that are likely to go bad, and charge it as an expense against the current period's revenue.  This  is because of two reasons:

  1. Any bad debts related to the debtors that are a result from the current period's credit sales is definitely an operating cost of that period and therefore, must be matched against the current period's sales revenue.  This is in line with the matching principle.  If the business waits until it knows for sure which debtor will definitely be irrecoverable and then charge it as a bad debt in that period, it may not be able to adhere strictly to the matching concept.  Say, a trade debtor of $400 arising out of a credit sale in December 1997 is definitely found to be irrecoverable in March 1998.  Suppose the business only charges this as a bad debt in 1998, what has happened is that whilst the sales revenue of $400 was reported in 1997, the cost of the bad debts expense arising out of that sale was only charged as an expense in 1998.  There was therefore no matching of revenue with the expense incurred to earn it.  To ensure that the expense is recorded in the same year that the sales revenue is recognized, the business should make a provision for doubtful debts at the end of every accounting period and charge it as an expense in that period.

  2. Once the provision for bad debts is calculated and entered into the accounts, the year-end Balance Sheet will show the total debtors less the total provision for bad debts up to that date.  This will be the approximate net amount that the business expects to collect - a mere conservative and accurate measure of its net asset 'Debtors'.  This is in line with the principle of conservatism.

An expense of this nature which cannot be calculated accurately at the moment is called a provision.

Provision for Discount Allowed (Discount on Debtors)

Some debtors may pay promptly and take advantage of any cash discount offered.  So the business must make a provision for this discount allowed on Sundry Debtors in anticipation of this reduction from total receipts of cash from its debtors.

There are two reasons for making the Provision for Discount Allowed:

  1. There is the need to record an item of expense in the same period that the related revenue is recognized.  In other words, the matching principle has to be applied.  Cash discount given to trade debtors who pay their bills promptly is considered an operating cost of selling goods sold on credit and should be charged as an expense in the same period that the sales is recognized.  Say, a credit sale of $500 was made on 28 December 1997.  Suppose the customer only settled his bill in 6 January 1998 after deducting $20 cash discount.  If this cash discount was only recognized and recorded as an expense in January 1998, then we realize that while the sales was recognized and recorded in as a revenue in 1997, the related expense to earn that sale, the cash discount, was only recorded in 1998 and charged as an expense against the revenue earned in 1998.  This is contrary to the matching principle.  Thus, to overcome this weakness, we make a Provision for Discounts Allowed based on the total net debtors (Debtors less Provision for Bad Debts) at the end of 1997 and charge it as an expense for 1997.

  2. When the total debtors in the year-end Balance Sheet is shown less Provision for Bad Debts as well as less Provision  for Discount Allowed, we will have a more conservative and truer estimate of total debtors.  This is in line with the principle of conservatism which recognizes all anticipated, though unrealized, losses.

 The Provision for Discount Allowed is always carried forward to the next accounting period as a current liability.

The Provision for Discount on Debtors is an expense and must be debited to the Profit and Loss Account on Balance Day.  To complete the double entry, the Provision for Discount Allowed Account is credited.  The Provision for Discount Allowed must also be deducted from the net amount of total Sundry Debtors, (i.e. Sundry Debtors less Provision for Bad Debts), otherwise, the amount of Sundry Debtors in the Balance Sheet will be overstated.

Exactly how much is set aside as a Provision for Discount on Debtors will depend on the past experience of the business.  Normally, it is calculated as a percentage of the net outstanding debtors.

Provision for Bad or Doubtful Debts, and Provision for Discount Allowed are made because of the need to:

Summary

  1. To write of bad debts - debit Bad Debts Account, and credit Debtor Account.

  2. To transfer bad debts for the year to the Profit and Loss Account - credit Bad Debts Account, and debit Profit and Loss Account.

  1. To bring into books recovery of bad debts - debit Cash Book, and credit  Recovery of Bad Debts Account.

  2. To transfer recovery of bad debts for the year to the Profit and Loss Account - debit Recovery of Bad Debts Account, and credit Profit and Loss Account.

  1. To create the provision - debit Profit and Loss Account, and credit the Provision Account (with the amount of provision for the year).

  2. To increase the provision - debit Profit and Loss Account, and credit the Provision Account (with the amount of increase in the provision for the year).

  3. To decrease the provision - debit the Provision Account, and credit Profit and Loss Account (with the amount of decrease in the provision for the year).

  4. How details are shown in Balance Sheet -

                       

  1. match expenses in the same year that the revenue is recognized (matching principle);

  2. show a more conservative and true figure for the net asset 'Debtors' in the Balance Sheet (principle of conservatism).