Some debtors may not pay up their accounts for various reasons e.g. a debtor may go out of business. When a debtor is not able to pay up his/her account this becomes a bad debt. Therefore the business/firm should write it off from the accounts and thus it becomes an expense that should be charged in the profit & loss account.
In practice a firm may also be unable to collect all the amounts due from debtors. This is because a section of the debtors will not honor their obligations. The problem posed by this situation is that it is difficult to identify the debtors who are unlikely to pay their accounts. Furthermore the amount that will not be collected may also be difficult to ascertain. These debts that the firm may not collect are called doubtful debts. A firm should therefore provide for such debts by charging the provision in the profit and loss account. Provision for doubtful debts maybe specific or general. Specific relate to a debtor whom we can identify and we are doubtful that he may pay the debt (if one of our debtor goes out of business).
Accounting for bad & doubtful debts.
When a debt becomes bad the following entries will be made:
- Debit bad debts account
Credit debtors account with the amount owing.
- Debit Profit and Loss Account.
Credit bad – debts account to transfer the balance on the bad – debts account to the Profit and Loss Account.
A provision for doubtful debts can either be for a specific or a general provision. A specific provision is where a debtor is known and chances of recovering the debt are low. The general provision is where a provision is made on the balance of the total debtors i.e. Debtors less Bad debts and specific provision. The accounting treatment of provision for doubtful debts depends on the year of trading and the entries will be as follows. If it is the 1st year of trading (1st year of making provision):
- Debit P&L a/c.
- Credit provision for doubtful debts (with total amount of the provision). In the subsequent periods, it will depend on whether if it is an increase or decrease required on the provision.
If it is an increase:
- Debit P&L a/c.
- Credit provision for doubtful debts (with increase only).
If it is a decrease:
- Debit provision for doubtful debts.
- Credit P&L a/c (with the decrease in provision only)