Bad Debts and Bad Debt Provision – Adjustments within Final Accounts

To understand the adjustment you need to understand the background as to what

exactly is a bad debt and a bad debt provision.

Bad debts arise when a trade debtor/ trade receivable is unable (or unwilling) to pay
the amount owed in respect of goods sold on credit. When a company becomes aware
of such a bad debt they can “write off” this bad debt. In other words recognise that
they are not going to receive this money even though they provided goods/ services so
as such the bad debt becomes an expense of the business. So the entry they make to
their books is:
Dr Bad Debts ( which creates/ increases the bad debt expense)
Cr trade debtor/ trade receivable ( which reduces this asset)

Now in the description above it is clear that the company would have to be aware that
a trade debtor/ trade receivable is unable (or unwilling) to pay the amount owed in
respect of goods sold on credit to write off a specific bad debt.

In preparing a set of year end accounts a company may not specifically know what
bad debts exist and so instead will want to “provide” for the fact that a certain element
of the trade debtor balances/ trade receivable balances at the year end may never be
recoverable. (The actual amounts that would not have been recoverable may not
become apparent until the next accounting period).

Usually the provision is based on some estimation/ judgement call made by the
management of the business.

Therefore a provision is the setting aside of income to meet a known or highly

probable future liability or loss, the amount and/or timing of which cannot be
ascertained exactly, and is thus an estimate.

A provision is a liability account so remember to increase a provision you need to

credit your provision account and to decrease a provision you need to debit your
provision account.

The bad debt provision reduces the amount receivable from customers at the year end
and appears on our Balance Sheet as follows:

A Balance Sheet Extract

Current Assets
Trade Receivables 100
Less provision for bad debts (5) 95

Let’s look at an example:

A Flower has a total trade receivables balance of €11,600 at the year end. He has
never provided for bad debts before but has decided that 2% of these trade
receivables may be bad. Make the necessary provision in the accounts:
Step 1: His best estimate is that 2% of his balances may be bad, therefore calculate the
amount of the provision:

 €11,600*2% = €232

This means that of the €11,600 due from customers it is likely that €232 will never be
recovered. To provide for this A Flower should:

Step 2: Make the necessary entry

Dr Bad Debt Provision /Expense €232

Cr Bad Debt Provision / Trade Receivables €232

Provision for Bad Debts – Liability Account

Provision
232 Provided 232

     

     

232   232

     

  Bal b/d 232

     

Bad Debt Expense – appears in the Income Statement

Provision 232 Bal c/d 232

     

232   232

     

Bal b/d 232

     
Step 3: Apply the entry to the financial statements

This is now an expense to A Flower and should be shown as an expense in the

Income Statement. This also reduces the amounts owing from customers:

A Flower Balance Sheet Extract

Current Assets
Trade Receivables 11,600
Less provision for bad debts (232) 11,368

In the next year A Flower has a balance of €12,400 and again estimates that 2%
may not pay.

Step 1: His best estimate is that 2% of his balances may be bad, therefore calculate the
amount of the provision:

i.e €248 ( €12,400 * 2%)

Step 2: Make the necessary entry

In the ledger there is already a provision for €232 from the previous year (see above)
so we need to adjust the provision. We have a provision of €232 we want it to be
€248. Therefore we need to increase the provision by €16. (€248-€232)

Increasing the provision means a bigger cost/ expense for the business and also means
we need to reduce the trade receivable balances by a greater amount than in the
previous period.

Therefore the necessary entry is to:

Dr Bad Debt Provision/ Expense 16 – this increases the amt of the expense.
Cr Bad Debt Provision (BS) 16 – this increases the amount of the
provision which will be seen on the Balance Sheet.

Note: BS = Balance Sheet

Step 3: Apply the entry to the financial statements

This €16 is now an expense to A Flower and should be shown as an expense in the
Income Statement. This also reduces the amounts owing from customers:

A Flower Balance Sheet Extract

Current Assets
Trade Receivables 12,400
Less provision for bad debts (248) 12,152
  Provision for Bad Debts  

bal c/d 248 Bal b/d 232  

    Increase in prov 16  

         

  248   248  

         

    bal b/d 248  

  Bad Debt Expense Account  

Increase in
Prov 16 Bal c/d 16

16 16

Bal b/d 16