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Hi Kara
Your methodology is fine although the bad debts written off and the provision increase are best shown separately.
If the bad debts have already been written off ie there is a bad debts written off account balance in the TB then the ‘other side’ of this entry would have been to credit debtors so the debtors shown in the TB are after the write off and do not need to be adjusted further.
If the bad debts to be written off is given as a NOTE to the TB then the debtors figure in the TB needs to be reduced by these so the double entry here is debit bad debts written off (p&l account) and credit debtors (balance sheet).
Some notes are:
Every business which deals on credit terms with its Customers will always hold a portfolio of debtors in its balance sheet as a current asset. In theory this should be just as good as cash but commercial reality and hindsight tells us that in practice not all customers will pay. If the ‘bad’ ones were known at the outset the business would never have traded with them on cash terms. Of courses this is not known so a provision based on the quantum and ‘age’ of the portfolio is made to allow for the fact that certain debtors will indeed default on the amounts which they owe the business.
If there is a decrease in the bad debt provision for the financial period under review then in the profit and loss account this could be deducted from expenses – or added to ‘other’ income . This is because a reduction in the bad debt provision means that, with hindsight, the provision has been overstated historically giving rise to a higher than needed expense which is now partially reversed.
To increase the sales, businesses may grant credit facilities to its customers. These customers become debtors, as they owe the money to the business. As long as you have debtors there is always a percentage of the debtors who may not be able to pay their accounts. Some debtors may, by nature, have an unwilling tendency to pay their debts. Other debtors may become insolvent or bankrupt, etc.
A business normally writes these debts off as irrecoverable for various reasons. This decreases the value of the outstanding debtors' accounts. Provision for bad debts are created because of the uncertainty regarding debtors settling their debts. Some people may refer to bad debts as irrecoverable debts and the provision for bad debts as provision for irrecoverable debts or even provision for doubtful debts.
To minimise the amounts written-off as bad debts and to make fair and reasonable estimates of provision for bad debts or irrecoverable debts, the some of the following considerations should be taken in account:
- Credit Control when granting credit facilities - If you have not carefully checked the credit worthiness of your debtors (on application for credit), your risk for bad debts will most probably, be very high (much higher than the bad debts of your competitors who have screened their debtors carefully). All the relevant information and credit agreement terms and conditions needs to be entered accurately on the Edit - Accounts - Debtors menu option if you create or edit Debtor accounts. Use credit limits to keep your debtor accounts within your credit agreement.
- Send Debtor Statements regularly to your Debtors.
- Utilise the Debtors Age Analysis Reports to follow outstanding amounts up and send reminders, letters of demand, etc.
- You may also allow early settlement discounts to encourage your debtors to pay or settle their accounts promptly.
The Provision for Bad Debts is calculated on the good book debtors. Before you can actually start to calculate provision for bad debts, you need to first identify those bad debts, which is irrecoverable and write the bad debts-off. You may have written bad debts-off during the course of the financial year.
The Provision for Bad Debts or Doubtful Debts is usually done at the end of your financial year, before you do a year-end (close the books). Once you have created provision for bad debts (in the fist year of your business existence or implementation of accounting policy), you need to revise and adjust the provision from year to year. To revise the provision, you may have to increase the provision or decrease the provision in the second year and onwards.
To create provision for bad debts, increase or decrease any provisions for bad debts is a separate transaction to that of writing off of physical irrecoverable or bad debts. There are basically 3 methods to calculate the provision for bad debts or doubtful debts, i.e.
- Estimates or calculations based on the age analysis schedules of your debtor accounts.
- Estimates or calculations based on the total outstanding debt.
- Estimates or calculations based on the total sales on credit.
Hope these notes help as this is a complicated area.
Regards
Brian
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