Bad debts and doubtful debts – The distinction
Bad debts and doubtful debts:
Selling goods or providing services to customers on credit is a routine activity in most businesses. The sum total or aggregate of the amounts which the customers owe to a business for purchasing goods on credit or services rendered or in respect of other contractual obligations is known as Sundry Debtors or Trade Debtors, or Trade Receivables, or Book-Debts. In other words, debtors are those persons from whom a business has to recover money on account of goods supplied or services rendered on credit. These debtors may again be classified as under:
Good debts: The debtors whose accounts are sure to be realized are called good debts.
Doubtful Debts: The debtors whose accounts may or may not be realized are called doubtful debts.
Bad debts: The debts that cannot be realized at all are called bad debts.
In this blog, we shall discuss how bad debts and doubtful debts are different from one another.
Bad debts and their treatment
When a business sells goods on a credit basis, some of the customers may fail to pay. Debts that cannot be recovered or become irrecoverable are referred to as bad debts.
Some of the reasons why a debt turns bad may be:
- The untimely death of a customer whose assets are insufficient to pay off debts
- When there is a disagreement/dispute with a customer
- When the debtor is declared insolvent by the Court and he is not able to pay the sum due
- When the customer is dishonest, and the party received goods on credit with no intention of repaying the debt
- When a customer is facing cash flow issues
- When customers face operational inefficiencies, such as strikes, lockouts, production disruptions, and so on, resulting in financial difficulties
If it is definitely known that the amount recoverable from a customer cannot be realized at all and all hopes of recovering the amount are lost, it should be treated as a business loss and must be adjusted against profit.
Thus, it is a loss to the business and is brought into account by debiting bad debts account and crediting debtors’ accounts that are not able to pay the amount. This loss is later on written off in the Profit and Loss Account on the debit side. Since it is no use showing the amount due still as an asset, the account of the concerned customer is closed by being credited.
The journal entry for recording bad debts in the books is as follows:
Bad Debts Account – Debit
– To Sundry Debtors Account – Credit
To transfer the loss to the statement of profit & loss, the bad debts account is debited to the profit and loss account.
For writing off bad debts:
Profit and Loss Account – Debit
– To Bad Debts Account – Credit
The debtors becoming bad are omitted from the list of sundry debtors and the amount is deducted from the figure of gross debtors. That is, in the balance sheet, the debtors’ balance is reduced by the amount not recoverable from debtors.
Sometimes bad debts that are written off are later on recovered in the following accounting year. In such a case, the recovered amount is credited to the Bad Debts Recovered Account and then shown in the credit side of the Profit and Loss Account as this represents a ‘gain’.
The entry for this is:
Bad Debts Recovered Account – Debit
– To Profit and Loss Account – Credit
Doubtful debts and their treatment
Debts that may or may not be realized in the coming financial year are known as doubtful debts. These are the debts whose collection cannot be ascertained with accuracy at the date of preparing the final accounts (i.e., the debts which are doubtful to realize).
From the date of sale to the date of the ultimate collection of debt, there always remains anxiety on behalf of the seller firm for which a seller makes provision from profit and loss account to secure such loss beforehand. Practically it cannot be regarded as a loss on that particular date, and as such, it cannot be written off. However, it should be charged against the Profit and Loss Account on the basis of past experience of debt collection in the firm.
For this, a firm may make a provision at the end of the accounting year for likely bad debts which may take place during the course of the next year.
This is for the basic reason that if out of the credit sales made during a particular year, some sales are likely to become ‘bad’ in the course of the next year, the proper course would be to charge P & L statement with such likely bad debts in the same accounting year in which the sales have been made.
It is also important to note that such a provision is to be created on the balance of debtors’ accounts (after reducing the current year’s bad debts) at a fixed percentage which may be based on past experience.
The following journal entry is passed for creating provision for doubtful debts:
Profit and Loss Account – Debit
– To Provision for Doubtful Debts Account – Credit
The provision for doubtful debts is charged to the Profit and Loss account.
It is also deducted from the debtors’ balance in the balance sheet.
This provision for bad debts created out of the profit of the current year is carried forward to the next accounting years. The bad debts that will arise in the next accounting year will be met out of this provision. In other words, bad debts when written off will be debited to “provision for bad debts” where such a provision exists in books.
For writing off bad debts against available provision:
Provision for Doubtful Debts Account – Debit
– To Bad Debts Account – Credit
Further, at the end of the next year, suitable adjustment entry is passed for keeping the provision for bad debts at an appropriate amount to be carried forward.
Sometimes the balance brought down from the last year is so huge that even after debiting the present year’s bad debts and leaving the desired balance at the end of the year, a surplus is left. This surplus is transferred to the credit side of the profit and loss account.
Example
If debts of 2020-21 prove to be bad in 2021-22, the loss is to be treated as one for 2020-21. But on 31st March 2021 when final accounts are to be prepared, it will not be possible to know accurately, which debts will prove bad in 2021-22. Therefore, only an estimate is made on the basis of past experience. If it is estimated that 6% of the debts may prove bad and on 31st March 2021 debtors amount to $40,000, then $2,400 will be provided for future bad debts.
The entry is:
Profit and Loss Account – Debit $2,400
– To Provision for Doubtful Debts Account – Credit $2,400
It will reduce the profit for 2020-21 by $2,400. Provision for bad debts will appear in the balance sheet as a deduction from sundry debtors on the assets side although it is a separate account showing credit balance.
In the next year, the actual amount of bad debts will be debited to “provision for bad debts account” which will then stand reduced. On 31st March 2022, the amount of the provision will be brought up by an appropriate debit to profit and loss account depending on the figure of sundry debtors (still awaiting to be realized) as of that date.
Key Takeaway
Bad Debt is a debt of which nothing can be recovered, and it is written-off as uncollectible (loss) in the books of account. On the other hand, doubtful debt is just an estimation of the amount whose collection is uncertain and may turn out as bad debt in the future.
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