BAD DEBTS AND PROVISIONS FOR BAD DEBTS

1
BAD DEBTS AND PROVISIONS FOR BAD DEBTS

• Most businesses which give credit terms to
  customers will reach a situation were a customer
  fails to pay for the goods, that is the business
  will incur a bad debt.

2
BAD DEBTS

• Bad debts should be shown as an expense in the
  Profit and Loss account when calculating the net
  profit or loss for the period.
• The other entry will be to remove the bad debt
  from the asset account (Trade Debtors).
• Usually, but not always, this means closing the
  debtors account.

3
EXAMPLE

• C. Bloom
• 2005 2005
• Jan 5
• Sales 50
• R. Shaw
• 2005 2005
• Feb 16 Aug 17
• Sales 240 Cash 200

4
EXAMPLE

• C. Bloom
• 2005 2005
• Jan 5 Dec 31
• Sales 50 Bad debts 50
• R. Shaw
• 2005 2005
• Feb 16 Aug 17
• Sales 240 Cash 200
• Dec 31
• Bad debts 40

5
EXAMPLE

• Bad Debts Account
• 2005 2005
• Dec 31
• C. Bloom 50
• R. Shaw 40
• Dec 31
• PL 90
• 90 90

6
EXAMPLE

• Profit and Loss Account
• Gross Profit XXX
• EXPENSES
• Bad debts (subtracted from gross profit)
  (90)

7
THE PRUDENCE CONCEPT

• Your lecture notes from week 1, outlined the
  concept of prudence according to SSAP 2.
• .anticipate no profit and provide for all
  possible losses.
• In SSAP 2 this was considered a fundamental
  accounting concept.

8
THE PRUDENCE CONCEPT

• In 1999, SSAP 2 was replaced by FRS 18.
• Prudence is now seen as one aspect of the overall
  objective of reliability,
• .the smoothing of reported profits has become
  as great a concern as their overstatement and, as
  a result, the deliberate understatement of assets
  and gains and the deliberate overstatement of
  liabilities are no longer seen as virtues.

9
PROVISIONS FOR DOUBTFUL DEBTS

• When preparing financial reports, none the less,
  it is important to be prudent, therefore we will
  want to
• To charge as an expense in the profit and loss
  account for that period, an amount representing
  debts that will never be paid, and
• To show in the balance sheet a debtors figure as
  close as possible to the true value of debtors
  (i.e. the amount the business actually expects to
  receive from customers) at the balance sheet
  date.

10
PROVISIONS FOR DOUBTFUL DEBTS

• Debts declared bad are usually debts that have
  been due for a long period of time.
• Nevertheless, it is likely that some of the more
  recent debtors will not pay the business.
• The prudence concept would suggest that this
  possibility should be taken into consideration
  now, otherwise both the debtor balance in the
  balance sheet and the profit reported in the
  profit and loss account will be overstated.

11
PROVISIONS FOR DOUBTFUL DEBTS

• To determine the potential debts which may not be
  paid, most businesses prepare an Aged Debtors
  Analysis.
• With the advent of computerised accounting
  packages, this can usually be obtained by a
  simple request.
• Past experience and judgement is required to
  assess the level of likely bad debts.
• Page 251 of your text, provides a sample of an
  aged debtors list.

12
PROVISIONS FOR DOUBTFUL DEBTS

• Due to the subjectivity involved in estimating
  the amount of potential bad debts, many firms
  simply apply a percentage to the overall debtors
  balance , i.e. the total of all the trade debtors
  after any declared bad debts are removed (in
  accounting this removal is referred to as
  writing-off the bad debts).
• The amount calculated is called the provision for
  doubtful debts or the bad debts provision.

13
ACCOUNTING ENTRIES FOR BAD DEBT PROVISIONS

• In the period (year) the provision is first made
• DEBIT the Profit and Loss Account with the amount
  of the provision (i.e. deduct it from gross
  profit as an expense).
• CREDIT the Provision for Doubtful Debts Account.

14
ACCOUNTING ENTRIES FOR BAD DEBT PROVISIONS

• At 31 December 2003, the debtors balance after
  deducting bad debts was 10,000.
• It is estimated that 2 per cent of the debts
  will eventually prove to be bad debts, and it is
  decided to make a provision for these now.

15
EXAMPLE

• Profit and Loss Account
• Gross Profit XXX
• EXPENSES
• Provision for doubtful debts (200)
• (Note subtracted from gross profit)

16
EXAMPLE

• Provision for Doubtful Debts A/c
• 2003
• Dec 31
• PL A/c 200

17
EXAMPLE

• Balance Sheet as at 31 December 2003
• CURRENT ASSETS
• Debtors 10,000
• Less Provision for
• doubtful debts (200) 9,800

18
BAD DEBTS AND BAD DEBT PROVISIONS

• Note there are two different accounts
• Bad Debts account, which is used when a specific
  debt has been declared bad and written off.
• Provision for doubtful debts account, which is
  used for estimates of the amount of the debtors
  remaining at the period end (year) AFTER the bad
  debts have been written off, that are likely to
  finish up as bad debts.

19
INCREASING THE PROVISION IN A SUBSEQUENT YEAR

• For the same business, at the end of the
  following year, 31 December 2004, the debtors
  figure (after writing off bad debts) is 12,000.
• The business decides that a provision for
  doubtful debts is still needed, and decides to
  maintain this at 2 per cent of total debtors.

20
EXAMPLE

• Provision for Doubtful Debts A/c
• 2003 2003
• Dec 31
• Dec 31 PL A/c 200
• Bal c/d 200
• 200 200
• 2004
• Jan 1
• Bal b/d 200
• Dec 31 PL A/c 40
• 2004
• Dec 31
• Bal c/d 240
• 240 240
• 2005
• Jan 1

21
EXAMPLE

• Profit and Loss Account
• Gross Profit XXX
• EXPENSES
• Provision for doubtful debts (40)
• (Note subtracted from gross profit)

22
EXAMPLE

• Balance Sheet as at 31 December 2004
• CURRENT ASSETS
• Debtors 12,000
• Less Provision for
• doubtful debts (240) 11,760

23
DECREASING THE PROVISION IN A SUBSEQUENT YEAR

• For the same business, at the end of the
  following year, 31 December 2005, the debtors
  figure (after writing off bad debts) is 10,500.
• The business decides that a provision for
  doubtful debts is still needed, and decides to
  maintain this at 2 per cent of total debtors.

24
EXAMPLE

• Provision for Doubtful Debts A/c
• 2005
• Jan 1 Bal b/d 240
• Dec 31 PL A/c 30
• Dec 31 Bal c/d 210
• 240 240
• 2006
• Jan 1 Bal b/d 210

25
EXAMPLE

• Profit and Loss Account
• Gross Profit XXX
• EXPENSES
• Reduction in Provision for doubtful debts (Added
  to gross profit) 30

26
BAD DEBTS RECOVERED

• Sometimes a debt which has been written off in a
  previous year is recovered, i.e. the customer
  does pay the business.
• The accounting treatment of this is as follows

27
BAD DEBTS RECOVERED

• Debit the debtors personal account to reinstate
  the debt.
• Credit a Bad Debts Recovery Account.
• When payment is received, debit the bank account
  and credit the debtors personal account.
• At the end of the accounting period, debit the
  Bad Debts Recovery Account and credit the Profit
  and Loss Account.
• Will the latter entry be subtracted or added to
  gross profit?

28
Q25.2

• A business had always made a provision for
  doubtful debts at the rate of 5 of total
  debtors, after any debts declared as bad has been
  written off.
• On 1 January 2007 the provision for this,
  brought forward from the previous year, was 260.
• During the year to 31 December 2007 the bad
  debts written off amounted to 540.
• On 31 December 2007, the remaining debtors
  (after the bad debts had been written off)
  totalled 6,200 and the usual provision for
  doubtful debts is to be made.

29
Q25.2

• You are required to show
• The Bad Debts Account for the year ended 31
  December 2007.
• The Provision for Doubtful debts Account for the
  year.
• Extract from the Profit and Loss Account for the
  year.
• The relevant extract from the Balance Sheet as at
  31 December 2007.

30
Q25.2

• Bad Debts Account
• 2007 2007
• Dec 31
• Debtors (various) 540
• Dec 31
• PL 540
• 540 540

31
Q25.2

• Provision for Doubtful Debts A/c
• 2007 2007
• Jan 1 Bal b/d 260
• Dec 31 PL A/c 50
• Dec 31 Bal c/d 310
• 310 310
• 2008
• Jan 1 Bal b/d 310

32
Q25.2

• Profit and Loss Account
• Gross Profit XXX
• EXPENSES
• Bad debts (540)
• Provision for doubtful debts (50)
• (Note subtracted from gross profit)

33
Q25.2

• Balance Sheet as at 31 December 2007
• CURRENT ASSETS
• Debtors 6,200
• Less Provision for
• doubtful debts (310) 5,890