Bad Debts & Provision for Doubtful Debts

1. Bad / Irrecoverable Debts

Definition: When a business sells goods on credit and the debtor doesn't pay the amount due, the debt is bad / irrecoverable. It is charged to profit & loss (income statement) as an expense when calculating the profit or loss for the period.

Possible scenarios for a bad debt (4 types)

1. Debtor refuses to pay one of several invoices — e.g. sold $100, $200, $300; says "won't pay the $100, will pay the rest" (goods faulty / disputed).
2. Debtor refuses to pay part of an invoice — e.g. 10 goods × $10 = $100; pays $80, withholds $20 (2 units faulty).
3. Debtor owes several invoices and says only a proportion will ever be paid because his business has failed — e.g. owes $1,000, can pay $600 ⇒ $400 is bad. (Most likely form: bankruptcy = liabilities > assets.)
4. Debtor's business has failed and nothing is ever likely to be received (not a single penny).

Double entry

• Why Dr Bad debts? It is an expense — an expense that increases is always debited.
• Why Cr Trade receivable? The asset (debtors) decreases — the debtor really refuses to pay. If the name is known write "Mr. Ali", otherwise "Trade receivables".
• Year end: all income/expense accounts are closed to the income statement. Bad debts has a Dr balance ⇒ credit it; Income Statement is debited (Dr IS = loss/expense; Cr IS = gain).

2. Provision for Doubtful Debts

Definition: Provision for doubtful debts is an estimate by management of the amount that can turn bad in future. Provision = estimate · doubtful debt = debt that may turn bad. We don't wait for the real bad debt — we are proactive: estimate it and book it immediately (this is an application of prudence).

Account	Used for
Bad debts a/c (expense)	When a debt is believed irrecoverable and is written off — it has actually gone bad.
Provision for doubtful debts a/c (contra asset)	Used only for estimates of the debtors remaining at year end after the bad debts have been written off that are likely to finish up as bad debts. (Also called the "provision for bad debts account".)

Why not just credit the trade receivables?

• The debtor has not yet refused to pay — it is only a doubt; he may still pay (an estimate, no surety).
• The amount belongs to all debtors (a general % applied), not to one customer.

So we open a new account instead: Provision for doubtful debts = a CONTRA ASSET.

Contra asset: anything that reduces the value of an asset. It is not an asset and not a liability, but its nature is like a liability ⇒ CREDIT (asset = Dr, so contra asset = Cr). So balance b/d is always on the credit side.

Double entries for the provision

	Debit	Credit	Effect
Create / Increase (new or bigger doubt)	Income Statement (expense)	Provision for doubtful debts	EXPENSE (bad news)
Reduce / Decrease (doubt falls)	Provision for doubtful debts	Income Statement (income)	INCOME (good news)

Provision for doubtful debts account (ledger)

Rules: b/d is on the CREDIT side · c/d is on the DEBIT side (it is a balance-sheet type account, so it is balanced and carried down). The shorter side is always the Income Statement.

Factors considered when deciding the provision (theory)

Factor	What it means
Past experience	bad debts in previous years guide next year's provision
Specific knowledge about a customer	we know a customer won't pay ⇒ provide for him specifically
State of the economy	recession / depression ⇒ people struggle, pay late ⇒ provide more
Present market & industry conditions	one sector in crisis (e.g. textiles, agriculture) and our big customers are there
Consistency concept	same basis each year — don't change % just to raise/lower profit; change only for genuine reasons
Industry average	every industry (chemical, retail…) has its own typical %
Age of debtors	older debt ⇒ higher chance it's bad ⇒ higher %
Size of debtors	very big are usually secured (guarantee/collateral), very small unlikely bad ⇒ medium debts are riskiest
Comparison with previous years / competitors	similar businesses' doubtful-debt %
Press release about the customer	news of trouble ⇒ adjust provision; if customer files for bankruptcy it becomes a bad debt, not a provision

3. Worked Example — ARD Ltd (videos 12 & 45)

Sir's own question (not a past paper) — it contains every basic technique examiners test. Business started in 2014 ⇒ opening provision = nil.

Step 1 — Bad debts account (both types go in!)

Don't separate "written off" and "needs to be written off" here: all go Dr Bad debts; year total → income statement. No b/d, c/d.

Step 2 — Provision calculation (working)

Step 3 — Increase or decrease in provision?

Year	Opening (b/d)	Closing (c/d)	Change	Effect on profit
2014	nil	2,877	↑ 2,877	expense (first year: always increase)
2015	2,877	4,200	↑ 1,323	expense
2016	4,200	3,456	↓ 744	income (good news)

Step 4 — Journal entries for the provision

2014 & 2015 = increase ⇒ Dr IS / Cr Provision. 2016 = decrease ⇒ reverse: Dr Provision / Cr IS (it's an income). Don't credit debtors — there is only a doubt, so credit the provision.

Step 5 — Provision for doubtful debts account

• Opening b/d is credit; the closing c/d is debit (the shorter side goes to IS as "Income Statement").
• Question stops at 2016 ⇒ bring down the balance for the next day: 1 Jan 2017 (for 2022 accounts → b/d in 2023).

Step 6 — Income statement extract (for the years ended 31 Dec)

Not a full income statement — only the part about bad & doubtful debts. Start with gross profit (unknown ⇒ write X); both income and expenses come after GP.

	2014 $	2015 $	2016 $
Gross profit	X	X	X
Add: Other income
Decrease (reduction) in provision for doubtful debts	—	—	744
Debts recovered (if any – see §6)
Less: Expenses
Bad debts (irrecoverable debts)	(9,100)	(3,500)	(5,700)
Increase in provision for doubtful debts	(2,877)	(1,323)	—

Step 7 — SOFP extract (as at 31 Dec)

	2014 $	2015 $	2016 $
Current assets
Trade receivables (after bad debts)	95,900	120,000	76,800
Less: Provision for doubtful debts	(2,877)	(4,200)	(3,456)
net trade receivables (no label needed)	93,023	115,800	73,344

3 ways to get the provision figure for the SOFP

1. Easiest: % × (receivables − bad debts to write off) — 2,877 / 4,200 / 3,456.
2. Roll forward from the income statement: 2,877 + 1,323 = 4,200; 4,200 − 744 = 3,456.
3. Take the balance c/d of the provision account each year.

4. Provision by Age of Debt (Andrea, Sofea, Umar)

Often the question gives different % for different ages: the longer a customer has not paid, the greater the chance it turns bad ⇒ the higher the %. Calculate each age-group separately and add up; the total is the closing provision (c/d).

A. Andrea — Paper 22, Nov 2011, Q2

(c) Compound journal entry — partial payment + write-off

• Bank Dr 500 (asset ↑ = Dr). Lost part = 2,500 − 500 = 2,000 → Bad debts Dr (expense). Keira's account cleared: Cr 2,500 (whole amount).
• This is a compound entry = one Cr + more than one Dr (or vice-versa). 1 mark per line = [3].
• If the examiner asks for a narrative, add the explanation line above. Here "narrative not required" — it is not asked ⇒ skip.

(d) Provision by age

(e) Provision for doubtful debts account (year ended 30 Sep 2011)

• Year ends 30 Sep 2011 ⇒ it started 1 Oct 2010 (opening b/d 1,300 on the credit side; c/d on the debit side).
• 1,300 → 1,220 = provision decreased by $80 ⇒ shorter side (debit) is the Income Statement ⇒ income ⇒ shows as "decrease in provision" under other income.

B. Sofea — provision at 29 Feb 2016 (year ended 29 Feb)

C. Umar — flat 5% provision

5. Why Keep a Provision? Prudence & Matching

Provision for doubtful debts applies two accounting principles (Andrea (f) / Zodwa (e), (f)):

Principle	Meaning	How a provision applies it
Prudence (conservatism)	Be careful / cautious: profit and assets must never be overstated. Show the true picture, don't exaggerate.	Without a provision the doubtful $ isn't charged ⇒ profit overstated (expense missing) and trade receivables (current asset) overstated.
Accruals / Matching	Income and expenses are matched to the same accounting period — it's the timing that matches, not the amounts.	Sales are made in year 1, but the bad debt shows only in year 2 ⇒ mismatch. Estimating a provision in year 1 puts the expense in the same year as the sale.

Worked idea (prudence): customers owe $1,000, of which $200 is doubtful. No provision ⇒ no $200 expense ⇒ profit too high; debtors shown at $1,000 instead of $800 ⇒ asset too high. Provision fixes both.

Worked idea (matching): sell goods in late 2022, customer might not pay in 2023. If the bad debt were recorded only in 2023 the 2022 income and its related expense would sit in different years ✗. So don't wait — create the provision in 2022.

Zodwa — past-paper theory questions (Q4)

6. Bad Debts Recovered (Irrecoverable Debts Recovered)

Definition: A customer who was previously written off as bad (we lost hope) suddenly pays — all or part (e.g. 30% / 50% of what he owed). It is the opposite of a bad debt: bad debt = expense (Dr) ⇒ debt recovered = income (Cr). It can only be recorded in a later year than the write-off.

Double entry

• Debit Bank directly (asset ↑). Writing Dr Trade receivable first is allowed but longer — you then need a 3rd entry (Dr Bank, Cr Trade receivable). Recommended: Bank.
• Write Bank unless the examiner says cash. Cash only if the question says cash.
• Never reopen the customer's account (we won't deal with him again) — credit a new income account.
• Do NOT credit the old bad debts expense account / don't net them: expense a/c and income a/c are separate.
• Entry ① is dated on the actual date of payment; the transfer to income statement ② is dated at year end (31 Dec), and only once even if there are several recoveries.

Examples

(b) Income statement (extract) for the year ended 31 Dec 2021
Gross profit	XXX
Add: Other income — Debts recovered	2,750
Less: Expenses — Irrecoverable debts	(XX)

If the transfer entry is also asked: Dr Debts recovered / Cr Income Statement. If the examiner doesn't mention a transfer, just the entry + narrative.

Extra (Andrea part g, sir's bonus): customer pays $2,925 (e.g. ≈ 70% of what was due) → Dr Bank 2,925 / Cr Bad debts recovered 2,925; year-end Dr Bad debts recovered / Cr Income Statement 2,925.

7. Full Chapter Cheat-Sheet

Situation	Debit	Credit	Where it ends
Debt goes bad (written off)	Bad debts	Trade receivable / customer	expense in IS
Year-end close bad debts	Income Statement	Bad debts	no b/d, c/d
Create / increase provision	Income Statement	Provision for doubtful debts	expense in IS
Reduce provision	Provision for doubtful debts	Income Statement	other income in IS
Debt recovered (received)	Bank	Bad debts recovered	income
Year-end close recovered	Bad debts recovered	Income Statement	other income in IS
Partial settlement + write-off	Bank (received) + Bad debts (rest)	Customer (whole debt)	compound entry