Bad Debt Provision

Article byWallstreetmojo Team
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

Bad Debts Provision Meaning

Provision for bad debts is the estimated percentage of total doubtful debt that must be written off during the next year. It is done because the amount of loss is impossible to ascertain until it is proven bad. It is nothing but a loss to the company, which needs to be charged to the profit and loss account in the form of a provision.

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Bad debt accounting is a practice of estimating the default from debtors or customers and the potential loss arising due to the same. By creating a provision, lenders can manage the risk by covering losses from doubtful or bad debts. The quantum of this provision depends highly on the lender’s risk appetite and their ability to recover doubtful debts.

Bad Debts Provision Explained

A bad debt provision is a reserve made to show the estimated percentage of the total bad and doubtful debts that need to be written off in the next year. It is simply a loss because it is charged to the profit & loss account of the company in the name of provision.

It is important to understand that debts are categorized into three categories. Understanding them shall act as a basis for our understanding of why passing a bad debt provision entry is vital to curtail potential losses in the business. The categories are:

  • Bad Debts: These means which are uncollectable or irrecoverable debts.
  • Doubtful debts: These means which will be receivable or cannot be ascertainable at the date of preparing the financial statements; in simple words, those debts are doubtful to realize.
  • Good debts: These means which are not bad, i.e., neither there is the possibility of bad debts nor any doubt about their realization is known as good debts.

Provision for bad debts can have a major impact on the financial statement of the companyFinancial Statement Of The CompanyFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more because it directly affects the profit and loss statement of the company, which is always required to give a true and fair view of the financial statements. Therefore, the estimation of the same should be made based on the company’s past performance.

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Journal Entries

Let us understand the journal entries passed for different scenarios where the debt from a potential defaulting customer is identified. The bad debt provision accounting process allows the management to prepare for potential losses.

In the First Year

  • For Bad debts
provision for bad debt journal entry 1
provision for bad debt journal entry 1-1
  • For provision for bad debts journal entries
provision for bad debt journal entry 1-2

In the Second/Subsequent Year

  • For Bad Debts
provision for bad debt journal entry 1-3
  •  For Provision for Bad Debts Journal entries (If a new provision is more than the old)
provision for bad debt journal entry 1-4
provision for bad debt journal entry 1-5

How To Calculate?

Now that we understand the basics and the formula relating to bad debt provision accounting, let us understand how to calculate the same through the discussion below.

There are two major ways through which the expenses relate to bad debt provision. They are- 1. Direct Write-off Method, and 2. Allowance Method.

  1. Direct Write-off Method: Under this method, the bad debts are directly debited from the bad debts account and credited to the account receivables. However, it is vital to understand that this method does not follow the balancing principle which affects the accrual accounting of the company. Following this formula does not require any formula as the amount defaulted will directly be accounted for in the respective account.
  2. Allowance Method: It is an appropriate method when a large volume of bad debt is involved. Under this method, a company forecasts the incurrence of bad debt from clients and prepares appropriate measures for the same.

A provision account is created to have a pool of money ready to be transferred to trade/account payables in case of default. It is a contra-asset account that reduces the loans receivable on the balance sheet.

Examples

Let us understand the concept of passing bad debt provision entry with the help of a few examples. These examples shall give us a practical overview of the concept and its related factors.

Example #1

Bad debts Account

Bad Debt Example 1

Provision for Bad debts Account

Bad Debt Example 1-1

Example #2

M/s X Ltd. has a trade receivableTrade ReceivableTrade receivable is the amount owed to the business or company by its customers. It is also known as account receivables and is represented as current liabilities in balance sheet.read more of Rs. 10000 from M/s KBC as of 31.12.2018. Recently, a receivable owing to Rs. 1,000 to M/s X Ltd has been wound up. Consequently, M/s X Ltd. does not expect an amount to be recovered from M/s KBC.

Based on experience, M/s X Ltd. estimates that 3% of its receivables will do the default in making the payments. M/s X should write offWrite OffWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more Rs. 1,000 from M/s KBC as bad debts. Please provide the journal entries to be made for bad debt. Note that the provision for bad debts on 31.12.2017 is Rs. 100.

The entries shall be made as under:-

Example 2
Example 2-1

(An allowance of Rs. 270 (i.e. (Rs. 10,000 – Rs. 1000) * 3%) should be made. A provision of Rs. 100 has already been created earlier. Therefore, only Rs. 170 shall be charged to the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. )

 Example #3

Let’s assume that, in 2017, we need to create the provision for bad debts @ 15% of the sundry debtors, i.e., $ 1,00,000, as we expect that these debtors will not pay their dues.

So, in the first year, i.e., 2017, we shall pass the following journal entry for provisions of bad debt as under:-

Example 3

At the end of 2018, we reviewed our sundry debtors, who were $ 1,10,000, and decided to provide the provision again at 15%. Accordingly, this year the provision will increase by $ 1,500 [($ 1,10,000 * 15%) – $ 15,000], and it shall be recorded in the books of accounts as under:-

Example 3-1

At the end of 2019, we again reviewed our sundry debtors, who were $ 90,000, and decided to provide the provision again at 15%. Accordingly, this year the provision will decrease by $ 1,500 [($ 90,000 * 15%) – $ 15,000], and it shall record in the books of accounts as under:-

Example 3-2

Based on the above, the following are the effects on the income statement:-

  • At the end of year 1:- Profit shall be lowered by $ 15,000
  • At the end of year 2:- Profit shall be lowered by $ 1,500
  • At the end of year 3:- Profit shall be increased by $ 1,500

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