Provisions, Reserves, and Bad Debts (Including Provision for Doubtful Debts)

Overview

In financial accounting, credit sales create debtors (accounts receivable). Some debtors may fail to pay and the resulting loss is treated as bad debts. To apply prudence and to show debtors at their realisable value, businesses create a provision for doubtful debts—an estimate of the portion of debtors that may become bad in future. Provisions and reserves are also important because they affect the measurement of profit and the presentation of financial position.

Key Terms

• Debtors / Accounts receivable — Amount due from customers for credit sales (e.g., customer owes ₹50,000).
• Bad debts — Debts that have become definitely irrecoverable (e.g., customer insolvent; nothing receivable).
• Doubtful debts — Debts whose recovery is uncertain (e.g., customer delaying payment; may default).
• Provision — A charge against profit made to meet a known liability or a probable loss (e.g., provision for doubtful debts).
• Reserve — An appropriation of profit created after profit is ascertained to strengthen the business (e.g., general reserve).
• Provision for doubtful debts — Estimated loss on debtors; shown as deduction from debtors in balance sheet.
• Bad debts recovered — Amount recovered later that was written off earlier; treated as income.

Bad debts: meaning and accounting treatment

Meaning

Bad debts are those debts which have become definitely irrecoverable. Once it is confirmed that the amount will not be received, it must be written off.

Accounting entry (write-off)

Bad Debts A/c Dr.
    To Debtors A/c

Effect:

• Debtors decrease (asset reduces).
• Bad debts are charged to Profit & Loss account as an expense (profit reduces).

Treatment in final accounts

• Profit & Loss A/c: Bad debts are debited as an expense.
• Balance Sheet: Debtors are reduced by the bad debts written off.

Doubtful debts and provision for doubtful debts

Meaning of doubtful debts

Doubtful debts are debts where recovery is uncertain. The debtor has not yet become insolvent, but there is a risk of non-recovery.

Why provision is created

Provision for doubtful debts is created because:

• Profit should not be overstated by assuming all debtors will pay.
• Debtors should not be overstated in the balance sheet.
• Prudence requires recognition of probable losses.

Accounting treatment (general)

At year-end, the required provision is compared with existing provision:

• If required provision > existing provision: the increase is debited to P&L.
• If required provision < existing provision: the decrease (excess) is credited to P&L.

Provision for doubtful debts: working and balance sheet presentation

Working (common exam format)

Provision is usually calculated on debtors after deducting further bad debts (if any).

Example working format:

1. Debtors (as per trial balance)
2. Less: Further bad debts (additional bad debts)
3. Net debtors
4. Provision required = Net debtors × given %
5. Compare with existing provision to find increase/decrease (transfer to P&L)

Balance sheet presentation (format)

This ensures debtors are shown at realisable value.

Bad debts recovered

Meaning

Sometimes an amount previously written off as bad debt is recovered later (for example, debtor pays after settlement).

Treatment

Bad debts recovered are treated as income in the year of recovery.

Entry (one common approach):

Cash/Bank A/c Dr.
    To Bad Debts Recovered A/c

Then:

Bad Debts Recovered A/c Dr.
    To Profit & Loss A/c

Provision vs reserve

Important idea: Provision is created because the expense/loss relates to the current period, even if exact amount is not known. Reserve is created by retaining profits.

Types of reserves (brief)

1) Revenue reserves

Created out of operating profits and generally available for dividend.

• General reserve
• Specific reserves (e.g., dividend equalisation reserve)

2) Capital reserve

Created out of capital profits and generally not available for dividend.

• Profit on sale of fixed assets
• Revaluation reserve (conceptual mention)

Quick recap (1-minute revision)

• Bad debts are actual irrecoverable losses → write off and charge to P&L.
• Provision for doubtful debts is estimated loss → charge to P&L and deduct from debtors.
• Bad debts recovered → income in the year of recovery.
• Provision = charge against profit; Reserve = appropriation of profit.