Provision for Bad Debts - Accounting Abstract

What is Provision for Bad Debts ?

Provision for Dad Debts, also known as an allowance for doubtful debts or allowance for bad debts, is an estimated amount set aside by a company to account for the possibility of some customers defaulting on their payments.

It is a contra-asset account that reduces the value of accounts receivable on the balance sheet.

Why Provision for Bad Debts is made ?

The provision for bad debts serves as a precautionary measure to reflect the anticipated losses from customers who may not be able to pay their outstanding debts.

It helps companies to match the estimated losses with the revenues earned in a specific accounting period, adhering to the principle of conservatism.

How Provision for Bad Debts is calculated?

The provision for bad debts is typically calculated as a percentage of the accounts receivable based on historical collection patterns, industry trends, and the overall creditworthiness of customers. This estimation is based on the company’s experience and judgment.

By establishing a provision for bad debts, companies can more accurately reflect the potential losses from uncollectible debts, ensuring a realistic valuation of accounts receivable and providing a more accurate representation of their financial position.

Presentation of the Provision for Doubtful Debts

The provision for doubtful debts is an accounts receivable contra account, so it should always have a credit balance, and is listed in the balance sheet directly below the accounts receivable line item.

The two line items can be combined for reporting purposes to arrive at a net receivables figure.

Journal Entry for Provision for Bad Debts?

The journal entry to record the provision for bad debts would be as follows:

The provision for bad debts is an expense recognized in the income statement, which reduces the company’s net income.
The contra-asset account, provision for bad debts, is reported on the balance sheet as a deduction from accounts receivable.

Example#1

For example, let’s assume that Company XYZ has accounts receivable of $100,000, and they estimate that 5% of these receivables will become uncollectible. They would make a provision for bad debts of $5,000.

Solution:

The journal entry to record the provision for bad debts would be as follows:

Example#2

As on 01.01.2022 Provision for Bad Debts is $5,000;

As on 31.12.2022 Bad Debts written off is $3,000 & Sundry Debtors are $1,25,000;

As on 12.2023 Bad Debts written off is $2,500 & Sundry Debtors are $1,00,000;

Provision for doubtful debts to be provided for 5% for 2022 & 2.5% for 2023;
Prepare Bad debts account and provision for bad debts account.

Solution:

Bad Debts Account

Provision for Bad Debts Account

Journal Entry for Bad Debts

Bad Debts Recovered Journal Entry