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Bad Debts Lecture Notes 5

Bad Debts Definition Bad Debt is an amount written off against a debtor who has failed to honour his obligations within a reasonable period, as a result of a credit transaction in the past. Bad Debt is charged direct to the debtor’s account so as to eliminate the amount owing, which is an asset of the Business.

Bad Debts How are Bad Debts Determined? The three most commonly used methods to determined Bad Debts are as follows: 1. A percentage of debtors based on past experience. 2.An examination of the accounts of individual debtor and listing debts likely to become bad. 3.Ageing Schedule. 4.Bad debt can either be written off to a Bad Debt account or written off against the provision for bad debts account.

Bad Debts Accounting Treatment The double entry is: – Debit the Bad Debt account – Credit the Debtor’s account with the amount written off. Actual debts are written off in the profit and loss account in the year that the debt is recognised as bad.

Bad Debts Bad Debt – Exercise Two debtors Lall and Greene owed the business $85 and $104 respectively from earlier transactions. Both debtors had failed to honour their obligation, but Greene only after making an earlier payment of $20 in relation to his debt of $104, some 18 months ago. The directors decided to write off both debts. Enter the transactions in the appropriate accounts.

Bad Debts Recovery of Bad Debt If bad debt is recovered during the next accounting period, we must re-open the account by: – Debiting the Debtor’s account and – Crediting Bad Debt account. To account for the receipt from the Debtor: – Debit the Cash account and – Credit the Debtor’s account. If the debt is recovered sometime in the future, – Credit the bad debt recovery account and – Debit the cash account with the amount received.

Provision for Bad Debts Lecture Notes 5

Provision for Bad Debts Definition A provision is any amount: – retained as reasonably necessary – for the purpose of providing for any liability or loss – which is either likely to be incurred, – or certain to be incurred – but uncertain as to amount or as to the date on which it will arise.

Provision for Bad Debts What is it? An account showing the expected amounts of debtors at the balance sheet who might not be able to pay their accounts. Why are they needed? The value of the debtors on the balance sheet will be showing too high a value and could mislead anyone. It allows for a more accurate calculation of profit and losses. It is in keeping with the matching principle of accounting

Provision for Bad Debts How are they different from Bad debts? Bad debts are amounts that the business is certain will not collect be collected. The provision for bad debts are best guesses of debts that will go bad. Provision for bad debts accounts are kept separate from the bad debts account. Bad Debts are written off and provisions for bad debt does not write off the debt. To make provision for bad debt is to – make provisions for possible bad debts. Bad debts are debts already bad.

Provision for Bad Debts Why make a Provision The provision for bad debts account is opened to cater for expected or probable loss. Provision for bad debt is seen as matching expenses of the period against revenue of that period.

Provision for Bad Debts How do they come about? K Charles who business begun on Jan 1, 2000 has sold goods for $50,000. Included in the total is a credit sale of $250 to C Young who has died. Besides that debt a credit sale of $550 to L Hall is unlikely to be paid. Hall’s 3 month credit ends on Jan 31, 2001, but K Charles has to produce a set of financial statements on Dec 31, Charles can’t wait until Jan 31, ‘01 to see if Hall will pay.

Provision for Bad Debts How to Treat a Provision for Bad Debt The provision is not entered into any debtor’s account, since the specific debtor who may default is not known. To create a provision for bad debt – – Debit the Profit and Loss account – Credit the Provision for Bad Debt account. To increase a provision – – Credit the Provision for Bad Debt account with the increase – Debit the Profit and Loss account with the said amount.

Provision for Bad Debts How to Treat a Provision for Bad Debt For a decrease in the provision – – Debit the Provision for Bad Debt account with the decrease – Credit the Profit and Loss account with a similar amount.