When someone owes you money, yet he or she is incapable of paying it, it is bad debt. Once you realise that the debts are bad, you have to remove it from the sales ledger and move them to a Bad Debts account by journal entry.
Provision for Doubtful Debts
Debt might not have become bad. However, it is possible to doubt as to whether your debtor (Accounts receivables) will settle it (Also see How Does Accounts Payable and Accounts Receivable Differs?). If not, it might develop into bad debt in the end. It would be confusing if you report that debt as an asset in your Balance Sheet as if that debt is not in doubt. Contrarily, you cannot write it off as it has not become a bad debt yet. When such condition occurs, a provision can come in handy as it can cover that as well as various other doubtful debts (Also see Permanent and Temporary Accounts).
Ways to Generate and Keep a Provision for Doubtful Debts
When you first generate the provision, you should debit the Profit and Loss account, as well as credit a provision for Doubtful Debts account by using the total of the provision during the Financial Accounting process (Also see Distinguishing Financial and Management Accounting).
In the years after that, the entries in the accounts are going to be for gains or drops in the sums needed for the provision:
In a successive gain in the provision, you should debit the Profit and Loss Account and what you have to credit is the provision. On the other hand, in a successive drop in the provision, you have to debit the Provision for Doubtful Debts while the account that needs to be credited will be the Profit and Loss Account.
You have to subtract the Provision for Doubtful Debts from the debtors in your Balance Sheet.
Ways to Calculate the Amount of a Provision for Doubtful Debts
The calculation of a provision for doubtful debts relies on the kind of provision needed. There are several types of provision, which are General, Specific, as well as Specific and general.
General: A company can determine the provision by calculating the percentage of the number of debtors. The average per cent of debts by the amount which shows to be bad is normally taken of this function.
Specific: A company has to choose some debts as doubtful ones from its sales ledger. The amount for the provision and the sum of these debts should be the same.
Specific and general: A company can calculate the provision by summing up the debts that it predicts to be doubtful and a percentage of the rest.
Accounting Concepts Related to the Provision for Doubtful Debts:
A provision for doubtful debts adheres to the accounting principles below:
Matching (Also see Relationship Between Matching Principle & Accounting Period): If a company realises that there may be a loss of income, it needs to record it within the period when they generate the profit, but not when it has become a bad debt in a later period.
Prudence: If a company expects to receive an amount from its debtors, it should not overstate it in the Balance Sheets. The Profit and Loss Account ought to record the loss of income, and it should not overstate the profit.
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