When a debtor fails to pay, the business must adjust its accounts so that debtors are valued prudently.
Bad Debts
A bad debt is a debt that is certainly uncollectible and is written off as an expense. The entry is: Dr Bad debts, Cr Debtor's account. Bad debts are transferred to the profit and loss account as an expense.
Bad Debts Recovered
Bad debts recovered occurs when a debt previously written off is later repaid. When the cash is received: Dr Bank, Cr Bad debts recovered. Bad debts recovered is income in the profit and loss account.
Key idea
Provision for doubtful debts = Percentage × Net debtors (after bad debts are written off). Net debtors in the statement = Debtors − Provision for doubtful debts.
Provision for Doubtful Debts
The provision for doubtful debts is an estimate of debts that may not be collected, following the prudence concept. Only the change in the provision is charged to the profit and loss account: an increase in the provision is an expense, while a decrease in the provision is income.
Example
Debtors balance is RM52,000. A bad debt of RM2,000 is written off, leaving net debtors of RM50,000. The provision for doubtful debts at 5% = RM2,500. If the previous provision was RM2,000, the increase of RM500 is charged as an expense. In the statement of financial position, debtors are shown as RM50,000 − RM2,500 = RM47,500.
Bad Debts versus the Provision
Distinguish the two: a bad debt is a certain loss where a specific debtor is written off in full, while the provision for doubtful debts is an estimate on the whole debtors balance. The provision is computed after bad debts are first written off. In an exam, the correct order is: write off the bad debts, find the net debtors, then compute the provision on that balance, and charge only the change in the provision to the profit and loss account.
Remember
Bad debts = expense. Bad debts recovered = income. For the provision for doubtful debts, only the increase or decrease is charged, not the full amount.