When debtors fail to settle their accounts for items sold on credit a bad debt will occur. A bad debt is an amount that is written off by the business as a loss to the business and classified as an expense because the debt owed to the business is unable to be collected, and all reasonable efforts have been exhausted to collect the amount owed. This usually occurs when the debtor has declared bankruptcy or the cost of pursuing further action in an attempt to collect the debt exceeds the debt itself.
The debt is immediately written off by crediting the debtor’s account and therefore eliminating any balance remaining in that account. A bad debt represents money lost by a business which is why it is regarded as an expense.
Doubtful debts are those debts which a business or individual is unlikely to be able to collect. The reasons for potential non payment can include disputes over supply, delivery, and conditions of goods or the appearance of financial stress within a customer’s operations. When such a dispute occurs it is prudent to add this debt or portion thereof to the doubtful debt reserve. This is done to avoid over-stating the assets of the business, as trade debtors are reported net of Doubtful debt. When there is no longer any doubt that a debt is uncollectable the debt becomes bad. An example of a debt becoming uncollectable would be: – once final payments have been made from the liquidation of a customer’s limited liability company, no further action can be taken.
To be considered as deductible, debts:
-must be a bona-fide debt, and
-worthless within the taxable year
An Ageing Debtors Schedule is set up where the debts are scheduled according to their age starting with from youngest to the oldest debts. This will assist in the calculation of bad debts, where the older debts are given a higher probability of bad debt, as well to determine those older debts that may not be collectible.
Provision for Bad Debts
A provision for bad debts is an estimation for bad debts on the balance of debtors at the end of the financial period.
-This bad debts provision expense attempts to allow as accurate as possible a calculation for bad debts for the year in which the debt occurred.
-It also allows for as accurate a figure for debtors at the date of the balance sheet.
Accounting entries for Bad Debts and Provision for Bad Debts
Both Bad debts and Provision for bad Debts are expenses and are therefore entered to Profit and Loss Account. However, only Provision for bad debts is entered to the balance sheet.
Below is an example
Enter up the Bad Debts account, Provision for Doubtful Debts Account, The Profit and Loss Account extracts, and Balance Sheet extracts for the relevant years from the table below.