Bad Debts and Provision for Doubtful Debts

Bad Debts and Provision for Doubtful Debts

Note: Bad Debts and Provision for Doubtful Debts are not the same thing

Bad Debts

A bad debt is a debt owing to a business that it considers will never be paid

If a firm has trade receivables to the total of 10,000 from a number of peoples
accounts some of these could become bad (not collectable). These must then be
written off and the company must accept the loss

Therefore you should: -

DEBIT bad debtors written off account

CREDIT the trade receivables account

with the relevant amount to be written off.

At the end of the year you should

DEBIT The Income Statement

CREDIT Bad Debts (written off) Account

With the total bad debts account written off as a company expense

This is in line with the concept of prudence which suggests that bad debts should be
recognized as they arise.
 Provision for doubtful debts

This is allowing for (hence the term provision) some of your trade rerceivables not
paying their bills. The firm will usually choose a specific percentage of trade
receivables based on previous experience, which can vary from business to
business (you may think of banks and hire purchase companies which may use a
higher figure).

This procedure comes after writing off bad debts

For example
Trade Receivables ₤10,000
Bad Debts ₤200
₤ 9,800
Provision of 2% ₤ 196
Balance sheet final total ₤ 9604
The ₤196 is then
Income Statement (as an expense called provision for doubtful debts)
Credit Provision for bad debts account

In the balance sheet it is then deducted as follows

Balance Sheet of Nial Satis as at 31/12/2003

Current Assets ₤ ₤ ₤

Stock 10,000
Trade Receivables 9800
Less prov for bad debts 196
9,604
Prepayments 1,000
Cash 2,500
Bank 9,950
33,054

Adjustments to the Provision for Bad Debts

Once a provision has been created the only adjustments needed are due to

· Policy change in provision (increase or decrease in percentage)

· Arithmetic adjustment in trade receivables total (this is quite likely each year)

When this happens the amount of the provision may increase or decrease.

An increase in provision for bad debts is recorded as follows

DEBIT the difference (new provision minus old one) to Income Statement *
 CREDIT provision for bad debts

* Note : In the Income Statement this is recorded as an increase in provision for bad
debts and listed in expenses

For the balance sheet the amount of the new increased provision is shown (i.e. the
larger amount)
An decrease in provision for bad debts is recorded as follows

Debit the difference (old provision minus new one) to provision for bad debts

Credit the Income Statement (this is recorded as reduction in provision of bad debt
account under income)

For the balance sheet the amount of the new provision is shown (i.e. the smaller
amount)

Minimising the risk of bad debts

It is appropriate to look at ways in which businesses selling on credit can minimise

the risks. The following are some of the procedures that can be followed:

· When first approached by an unknown business wishing to buy goods on credit.

the seller should ask for two references. One of these should be the buyer's bank,
and the other a trader with whom the buyer has previously done business.

· The seller, before supplying goods on credit, should take up both references and
obtain satisfactory replies.

· Once satisfactory replies have been received, a credit limit for the customer
should be established, and an account opened in the sales ledger. The amount of
the credit limit will depend very much on the expected amount of future business - for
example, £1,000 might be appropriate. The credit limit should not normally be
exceeded - the firm's credit controller or financial accountant will approve any
transactions above the limit.

· Invoices and month-end statements of account should be sent out promptly;

invoices should state the terms of trade, and statements should analyze the balance
to show how long it has been outstanding, e.g. 'over 30 days, over 60 days, over 90
days' - computer produced statements can show this automatically.

· If a customer does not pay within a reasonable time, the firm should follow
established procedures in' order to chase up the debt promptly. These procedures
are likely to include 'chaser' letters, the first of which points out that the account is
overdue, with a later letter threatening legal action. Whether or not legal action is
taken will depend on the size of the debt - for a small amount the costs and time
involved in taking legal action may outweigh the benefits of recovering the money.