Difference Between Bad Debts Written Off And Provision For Doubtful Debts.

June 19th, 2006 Comments off
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WHAT IS BAD DEBT WRITTEN OFF?

Nowadays the company needs to extend credit to its customers. If the company insists on cash term, it will drive away the customers. This might be worsened if other competitors are able to extend generous credit terms to the customers.

In the real world of doing business, there will definitely be some of these customers that cannot pay up their debts.

To ensure that this type of doing business expenses can be charged/expensed off into the Income Statement so that the profit will not be overstated, we need to create an accounting entry called bad debt written off. What’s it really mean is to write off the irrecoverable amount of the trade debtors and directly charged/expensed into the Income Statement.

Illustration:

Say the Company has an accounting period from 1 st January to 31 st December. It has billed customer A for $10,000 in mid- January’06. By September’06, customer A only paid $8,000. The customer A has become bankrupt and has absconded leaving the amount $2,000 unpaid.

(1) The original double entry when the Company billed customer A is:

Debit : Trade Debtor (Balance Sheet)  $10,000

Credit: Revenue( Income Statement)  $10,000

(2) Next, the Company needs to initiate the following entry to write off the bad debt of customer A:

Debit: Bad Debts Written Off (Income Statement) $2,000

Credit: Trade Debtor Accounts ( Balance Sheet ) $2,000

However, we need to understand that bad debt write off is not consistent with the Matching concept.

The billing to the customers might not really turn irrecoverable or bad during the year it has been billed. Say for the above illustration, we assume that customer A only become a real bankrupt and has absconded only in the middle of year 2007. So what should the Company do?

Hence, the need to look at another way of handling this irrecoverable debt which is called:

PROVISION FOR DOUBTFUL DEBTS:

Provision For Doubtful debts takes into consideration that when a company conducts it business, there is bound to be some billings during the year whereby the customers might not be able to pay hence eventually turning bad. If this occurs during the accounting year then the company can DIRECTLY write it off  in the Income Statement, otherwise a Provision needs to be created for these doubtful customers.

Illustration:

Debit: Provision for doubtful debts ( Income Statement)  XX

Credit: Provision for doubtful debts ( Balance Sheet)       XX

Being provision for doubtful debts

For Balance Sheet’s presentation:

Trade Debtors  YYY

Less: Provision for doubtful debts  (XX)

Net Trade Debtors ZZZ

[ In my earlier article on provision, this provision for doubtful debt instead being a credit amount and classify as liabilities, it is classify as an asset side SO AS TO REDUCE THE VALUE OF THE ASSET in this case, Trade Debtors Account.]

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