Provision for Doubtful Debts - Practical Accounting Treatment - Finance Ppl

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Provision for Doubtful Debts - Practical Accounting Treatment

Provision for doubtful debts (also called allowance for doubtful accounts) is an adjustment made in financial statements to account for the possibility that some receivables may not be collected. It ensures that reported profits and assets are not overstated.

Journal Entries

Practical treatment is divided into the initial creation, annual adjustments, and final write-offs.

  1. Creation of initial Provision:

    2. At the end of each accounting period, businesses review outstanding debtors (AR). Business may estimate/anticipate a portion of debtors to turn irrecoverable, based on past experience or aging schedules or risk assessment and shall create provision for the same. The entry for which would be:

    Profit and Loss A/c Dr
    To Provision for Doubtful Debts A/c

    This Provision is anticipatory and serves as cushion against future losses.

  2. Presentation in Balance Sheet

    3. Accounts Receivable ie Debtors a/c is shown net of provision. Note that Provision is a contra-asset account that reduces receivables.

    Line Item Amount
    Debtors XXX
    Less: Provision (XX)
    Net Debtors XXX

  3. Adjusting in Subsequent Years

    4. Provision for doubtful debts is reviewed annually, based on updated estimates of receivables risk. The current provision is adjusted to match the new estimated percentage of closing debtors.

    1. Suppose, If New Estimate < Old Provision, then additional provision shall be made and the entry shall be same as entry for creation of initial provision, which is :

      Profit and Loss a/c Dr
      To Provision for Doubtful Debts a/c

    2. If New Estimate > Old Provision, then reversal of provision needs to be done. (because fewer debts are expected to go bad), for which the entry would be :

      Provision for Doubtful Debts a/c Dr
      To Profit and Loss a/c

    But remember, reversal of provisions can’t be made just like that (casually). It must be backed by clear evidence (recovery pattern, improved creditworthiness etc) and careful judgement.

    Some business have this practice of reversing provisions to boost the profit. It is pertinent to note that frequent arbitrary reversals distort comparability of financial statements across years.

  4. Actual Bad Debts Written Off

    5. When a debt (debtor) is officially confirmed as uncollectible, the outstanding balance is written off against the existing provision made wrt that debtor. Write off entry for which would be:

    Provision for Doubtful Debts A/c Dr
    To Debtors A/c

    Basically, the provision already created, acts like a buffer. When actual bad debts arise, the provision balance is utilized (reduced) to absorb the confirmed bad debt, ensuring no double charge to Profit and Loss a/c.

    If actual bad debts exceed the provision, only then, the excess is charged to Bad Debts, meaning the Profit and Loss a/c takes a fresh hit.