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To understand the calculation for Provision for Bad and Doubtful Debts, one should first be familiar with the meaning of the term Provision for doubtful debts and why it is maintained by an organization.
Provision for Bad and Doubtful Debt
Provision for bad and doubtful debt is a contra asset which means it reduces the balance of an asset specifically the receivables.
When an entity executes transactions of sales on a credit basis it creates and adds on to the amount due from sundry debtors. These sundry debtors, as per the agreed terms are liable to make a payment for such goods purchased before the end of the credit term.
If such debtor continuously makes a default such debtor shall be considered as a bad debt for the organization. When an entity remains doubtful regarding the recovery of its revenue i.e. it has a reason to believe that such an amount due to be received may not be realized, the entity shall create a reserve or a provision for doubtful debts.
As per the Prudence Concept of accounting, an entity must not anticipate profits, but prepare for all possible future losses. By maintaining this provision, an entity prepares itself for any future losses due to bad debts.
How is it calculated?
The table given below will help you to understand step-by-step calculations to compute provision for doubtful debts
| Particulars | Amount |
| Old Bad Debts (It shall be given in the Trial Balance on the Dr side) | amt |
| Add: New Bad Debts (It shall be given in the adjustment) | amt |
| Add: New Bad Debt Reserve (Debtors x %/100) (It shall be given in the adjustment) i.e (% of Debtors – New Bad Debts) | amt |
| amt | |
| Less: Old Provision for Bad Debts (It shall be given in the trial balance on the credit side) | (amt) |
| New Provision/Reserve for Bad Debts | amt |
For Example,
An extract of the Trial Balance of ABC Ltd. is given below:
| Particulars | Debit | Credit |
| Bad Debts | 400 | |
| Reserve for Bad Debts | 1,500 | |
| Sundry Debtors | 16,000 |
Adjustment: Provide a 2% reserve for bad and doubtful debts on the debtors. It was realized that our debtor worth 1000 proved to be bad and has been written off.
| Particulars | Amount |
| Old Bad Debts (Given in Trial Balance) | 400 |
| Add: New Bad Debts (posted from adjustment) | 1,000 |
| Add: New Bad Debt Reserve (Debtors x %/100) (It shall be given in the adjustment) i.e (% of Debtors – New Bad Debts) = (16,000 – 1,000) X 2 % | 300 |
| 1,700 | |
| Less: Old Provision for Bad Debts (Giving effect to an adjustment) | (1,500) |
| New Provision/Reserve for Bad Debts | 200 |
Hence, the company should create a new provision of 200 for the current financial year.
Generally, the provision for doubtful debts is created based on the entity’s experience in the business and various other factors. An organization must assess the risk associated with each customer. It should analyze the previous payment patterns of the debtors, their credit ratings, financial conditions, etc.
The organization may conduct an aging analysis of the receivables. In simple terms, it means to analyze the receivables based on how long the invoice has been outstanding. For example, the invoices may be current, 30-45 days past the due date, 45-60 days past the due date, 120 days past, or so on. On the basis of this analysis, the organization may determine which debtors are more likely to default and prepare the Provision for doubtful debts accordingly.
Conclusion
The above discussion may be summarised as follows:
- When a debtor does not pay the debt owed by him to the organization, it becomes a bad debt for the business.
- To prepare for such future losses, the business must maintain a Provision for Bad and Doubtful debts.
- The provision is created based on the entity’s experience in the business and various other factors.
- Generally, a percentage of the total amount due from debtors is kept aside as Provision for doubtful debts.