Provisions for Doubtful Debts, Meaning and Accounting Treatment

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.

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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.

Why is Provision for Doubtful Debts Important?

Creating a provision for doubtful debts is essential for multiple reasons:

• 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.

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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