What is meant by provision for doubtful debts? How are the relevant accounts prepared and what journal entries are recorded in final accounts? How is the amount for provision for doubtful debts calculated?
Provision for doubtful debts is created because it is a normal feature of business operations that some debts prove irrecoverable. Since it is not possible to accurately know the amount of such bad debts, a reasonable estimate of the potential loss is made to bring certainty to the amount charged against income each year.
The amount for provision is calculated as a percentage of the sundry debtors at the end of the accounting period (e.g., 5%). When calculating the final charge to the Profit & Loss Account, one must consider the Bad debts (from Trial Balance), any Further bad debts (from adjustments), the New provision (calculated on current debtors), and the Old provision (balance from the previous year).
The relevant journal entries recorded are:
- To record further bad debts: Bad Debts A/c Dr. to Sundry Debtors A/c.
- To close the Bad Debts account: Provision for Doubtful Debts A/c Dr. to Bad Debts A/c.
- To create the new provision: Profit & Loss A/c Dr. to Provision for Doubtful Debts A/c.
In the Profit & Loss Account, the total of Bad debts, Further bad debts, and New provision is shown on the debit side, while the Old provision is deducted on the credit side. In the Balance Sheet, the New Provision is shown as a deduction from Sundry Debtors on the Assets side to reflect the estimated realizable value.
Explanation
The answer is derived directly from the textbook context provided. The definition comes from the section explaining that some debts are irrecoverable and a provision brings certainty to losses (Chunk 3). The calculation method and the adjustment of old vs. new provision are based on the example and table in Chunk 5. The journal entries are listed exactly as they appear in Chunk 4, and the presentation in the Final Accounts follows the format shown in the Profit & Loss extract and the note in Chunk 2 stating it is deducted from debtors.
Solution Steps
Step 1: Define Provision for Doubtful Debts as an estimate of irrecoverable debts to match losses against income.
Step 2: Calculate the amount by summing Bad Debts and New Provision, then subtracting the Old Provision.
Step 3: Record journal entries for further bad debts, closing the bad debts account against the provision, and charging the new provision to Profit & Loss.
Step 4: Show the net charge in Profit & Loss Account and deduct the New Provision from Debtors in the Balance Sheet.