Accounting For Bad Debts and Provision for Doubtful Debts

For most business, except supermarkets and cash intensive business, most of the  sales are on credit. As a result there is always a risk of default. Customers may fail to pay for so many reasons including cash flow issues and sometimes they may collapse before they make their payments. In the case where it is established that the customer will never pay for the goods that were sold to them then the business needs to recognise this as a bad debt.

Scenarios That May Lead To Customers Defaulting

• The customers business may collapse and therefore they are only able to pay part of what they ower or they can altogether not be able to pay anything.
• The customer may refuse to pay for the supply of goods for instance because they are disputing it. This could a whole invoice or part of an invoice.

A bad debt needs to be recognised as an expense and charged to the profit and loss statement (income statement). This is because initially this was recognised as revenue but now that revenue needs to be "derecognised" in calculating the profit and loss for the period.

Besides charging it to the profit and loss we also need to get rid of it from the debtors ledger. In other words the asset that was recognised when we sold the goods needs to go. The asset that was recognised in the debtor's account is now worthless. It needs to be eliminated.

In summary you clear bad debts by crediting the debtor's account to cancel the asset and increasing the expense account of bad debts by debiting it there.

Dr. Bad Debts (P/L)

Cr. Debtors. (BS)

At the end of the period the balance in the Bad debts account will be transfered to the profit and loss account

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