Bad debts, provision for doubtful debts and provision for cash discount
Mostly, large scale businesses make sales on credit; that is they do not receive cash at the spot for the goods they sell. The parties which owe the business an amount are called debtors and the amount is called debt. Debtors are treated as current assets. However, it is equally possible that not all the debtors would pay back all the amount they owe. The amount which is not paid due to any reason and is not expected to be paid in the future is called “bad debt”. Bad debts are recorded in the journal by debiting the bad debt account and crediting the debtor’s account. At the end, total of the bad debts account is transferred to the Profit and loss account.
Debit bad debts account
Credit debtor’s account
Businesses have a fair idea of how many debts would be paid and how many will be rejected. So , as a precaution , businesses set aside a amount of money to pay for the debts that may turn bad over the period of time. This precautionary measure is termed as “provision for doubtful debts”. Making provision for doubtful debts means even if some of the debts turn out to be bad, they wont effect the profit and loss account.
Provision for bad debts is recorded in the books as
Debit the profit and loss account for the amount to be deducted from the gross profit. (treat as expense)
Credit the provision for doubtful debts account.
NOTE : in the balance sheet, balance of the provisions for doubtful debts would be deducted from debtors.
Both bad debts and the provision for bad debts are deducted from gross profit
When provisions for doubtful debts have to be increased say for example because the provisions have to be 2 % of the total debtors. The total debtors have now risen to $1200, 2% of $1200 is $240. Provisions brought down from last year are $200. We would increase the remaining $40 by making the following entries
Debit profit/loss account (treat it as expense)
Credit provision for doubtful debts account.
To reduce the provision, exact opposite is done.
NOTE : in the balance sheet the entire figure for provision for doubtful debts (original +- change) is deducted, but in the profit and loss account only the change is recorded.
Recovery of bad debts
Rarely seen, however the possibility of recovery of a bad debt written off previously is still present. When this happens we record it by making the following entries
Debit debtor’s account
Credit bad debts recovered account
The balance in the bad debts recovered account is then transferred to the credit side of the profit & loss account at the end of the year.
Provision for cash discounts
Some businesses maintain a provision for cash discounts for the net debtors. This means that the cash discounts allowed would not effect the profit at the end of the period.
Provision for cash discount is treated exactly as provision for doubtful debts.