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What is the purpose of creating a provision for doubtful debts?
The primary purpose of creating a provision is to anticipate potential losses from customer defaults and ensure that the accounts receivable are not overstated in the balance sheet. It supports accurate and transparent financial reporting.
Is provision for doubtful debts shown as an expense?
Yes, the provision is treated as an expense in the Profit and Loss Account in the year it is created or increased. In subsequent years, only the difference (increase or decrease) is reflected as an expense or income.
How is provision for doubtful debts different from bad debts?
Bad debts are amounts confirmed as uncollectible and are directly written off. In contrast, a provision for doubtful debts is an estimate created in advance for debts that may become uncollectible in the future.
Can a provision for doubtful debts be reversed?
Yes, if the estimated risk decreases in the following year, the excess provision can be reversed by crediting the Profit and Loss Account. This ensures the provision remains in line with actual risk.
Provisions for Doubtful Debts, Meaning and Accounting Treatment
Learn the meaning and accounting treatment of provision for doubtful debts, including journal entries, and examples, and how it impacts balance sheets and profit & loss accounts.
Muskan Verma5 Apr, 2025
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In accounting, maintaining transparency and reliability in financial statements is crucial. One such essential concept is the provision for doubtful debts, which helps ensure that the reported figures reflect a more realistic view of a company’s financial health. This article covers the meaning, need, and accounting treatment of provisions for doubtful debts, with practical examples to enhance understanding.
What is Provision for Doubtful Debts?
A provision for doubtful debts is an estimated amount set aside by a business to cover potential losses arising from customers who may not pay their dues. These are debts considered doubtful due to reasons like the customer’s insolvency, prolonged delay in payment, or any other sign that collection may be uncertain.
This provision is a part of the prudence concept of accounting, which suggests that anticipated losses should be recorded, but anticipated gains should not. By making such provisions, businesses avoid overstating their assets or net profits.
Reflects true financial position: It helps present a more accurate value of receivables in the balance sheet.
Ensures consistency: Regular provisioning maintains uniformity in the accounting process.
Protects future profits: It prevents sudden shocks in future years due to bad debt write-offs.
Supports better decision-making: Lenders, investors, and other stakeholders can make informed decisions based on realistic figures.
Difference Between Bad Debts and Doubtful Debts
This table compares bad debts with doubtful debts to clear up common confusion.
Difference Betwwen Bad Debts and Doubtful Debts
Basis
Bad Debts
Doubtful Debts
Meaning
Amounts confirmed as irrecoverable
Amounts that may become irrecoverable
Treatment
Written off from accounts
Provision is created as a reserve
Impact on P&L
Direct expense
Estimation (expense) for possible loss
Certainty
Confirmed loss
Possible loss
When is a Provision for Doubtful Debts Created?
A provision is created at the end of an accounting period, based on a percentage of the outstanding accounts receivable. Businesses often rely on historical data and industry practices to estimate the provision.
Example:
If a business has ₹5,00,000 as total debtors and based on past trends, 5% may turn bad, a provision of ₹25,000 will be created.
Accounting Treatment of Provision for Doubtful Debts
Here we dive into the step-by-step accounting process for creating, adjusting, and using provisions.
1. Creating the Provision
At the end of the year, an entry is passed to create a provision:
Journal Entry:
Profit and Loss A/c Dr.
To Provision for Doubtful Debts A/c
(Being provision created at __% on sundry debtors)
2. Adjusting Provision in Subsequent Years
If a provision already exists, the required adjustment is made to match the new estimate. This can result in either increasing or decreasing the provision.
If provision increases:
Profit and Loss A/c Dr.
To Provision for Doubtful Debts A/c
(Being increase in provision)
If provision decreases:
Provision for Doubtful Debts A/c Dr.
To Profit and Loss A/c
(Being excess provision written back)
3. Writing Off Bad Debts Against Provision
When a debt becomes bad in the following year, it is adjusted against the provision instead of affecting the P&L account.
Journal Entry:
Provision for Doubtful Debts A/c Dr.
To Sundry Debtors A/c
(Being bad debts written off against provision)
How to Show Provision in Financial Statements
Understanding how to present provisions in financial reports is essential for compliance and clarity.
Balance Sheet Treatment
Provision for doubtful debts is shown as a deduction from sundry debtors under current assets:
Sundry Debtors ₹5,00,000
Less: Provision ₹25,000
Net Debtors ₹4,75,000
Profit and Loss Account
In the first year: Full provision is shown as an expense.
In subsequent years: Only the change (increase or decrease) in provision is shown.
Practical Example
Let's say, for FY 2024-25:
Debtors: ₹2,00,000
Existing provision: ₹5,000
New requirement (5% of ₹2,00,000): ₹10,000
Journal Entry:
Profit and Loss A/c Dr. ₹5,000
To Provision for Doubtful Debts A/c ₹5,000
(Being increase in provision from ₹5,000 to ₹10,000)
Now, suppose ₹6,000 becomes bad in FY 2025-26:
Provision for Doubtful Debts A/c Dr. ₹6,000
To Sundry Debtors A/c ₹6,000
(Being bad debt adjusted from provision)
Key Points to Remember
Provision is an estimate, not a confirmed loss.
It helps maintain accuracy and transparency in reporting.
Adjustments are made every year based on the closing balance of debtors.
Provision affects both the P&L account and balance sheet.
It is not a cash outflow but an accounting adjustment.
The provision for doubtful debts is a prudent accounting practice that ensures financial statements do not overstate assets or net profits. Whether you are a commerce student or a professional accountant, understanding its meaning, accounting treatment, and impact on financial reports is crucial. This reflects sound financial judgment and supports informed decision-making for all stakeholders.
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