Provision for Doubtful Debts (Cambridge International IGCSE Accounting)

Provision for doubtful debts

What is a provision for doubtful debts?

• A provision for doubtful debts is an estimation for the amount of sales in a given financial period which will result in irrecoverable debts

• The amount for the provision for doubtful debts can be determined using different methods

  • It could be a fixed percentage of the trade receivables at the end of a financial period
  • It could be a fixed amount based on data from previous years
  • It could factor in how long debts have been outstanding
  • It could be based on which individuals are unlikely to settle their debts

• A business should use the same method for accounting for doubtful debts each year

  • This adheres to the accounting principle of consistency

• A provision for doubtful debts is similar to a provision for depreciation of a non-current asset

  • The provision for doubtful debts estimates a reduction in an asset

    • The asset is the amount owed by trade receivables

  • However, the reduction is kept in a provision account which is separate from the asset accounts

Why do businesses set up a provision for doubtful debts?

• Businesses use a provision for doubtful debts to adhere to the accounting principles:

  • Prudence
  • Matching

• The principle of prudence is applied because:

  • The assets are not overstated

    • The provision reduces the trade receivables by a realistic amount

  • The profit for the year is not overstated

    • The potential losses are factored into the expenses

• The principle of matching is applied because:

  • An estimate of irrecoverable debts is made based on sales in a given period
  • This estimate is then treated as an expense for the same period as the original sales

How do I set up a provision for doubtful debts?

• The provision is set up at the end of the financial period

• The business estimates the amount of sales in that period that will result in irrecoverable debts

  • This is normally a percentage of the trade receivables at the end of the financial period

• This amount is debited to the income statement as an expense

  • A credit entry is made in the provision for doubtful debts account

• The balance of a provision for doubtful debts account will be on the credit side because it represents a reduction in an asset

Exam Hint No entries are made in any account in the sales ledger for the provision of doubtful debts. Entries are made in these accounts when debts are actually written off.

Worked Example On 31 March 2024, Josef is owed $42 000 by credit customers. Josef decides to create a provision for doubtful debts, set at 5% of trade receivables.

Prepare journal entries for the creation of a provision for doubtful debts account on 31 March 2024. A narrative is not required.

Journal

Date	Details	Debit $**	Credit **$

Answer:

• Calculate the provision for doubtful debts

5% × $42 000 = $2 100

• Start with the account to be debited

  • The income statement

• Then include the account to be credited

  • The provision for doubtful debts account

Journal

Date	Details	Debit $**	Credit $
Final answer: 2024 Final answer: Mar 31	Final answer: Income statement	Final answer: 2 100
	** Provision for doubtful debts		Final answer: 2 100

Adjustments to a provision for doubtful debts

How do I update a provision for doubtful debts at the end of a financial period?

• The provision for doubtful debts is reviewed at the end of each year and the amount might be updated

• At the end of the financial period

  • Calculate the new provision for doubtful debts

  • This will be the opening balance of the provision for doubtful debts account for the next financial period

    • Enter it on the credit side

  • Enter the corresponding closing balance on the debit side of the provision for doubtful debts account for the current financial period

  • Calculate the difference and enter it on the appropriate side to make the account balance

    • This value will be transferred to the income statement

• If the provision for doubtful debts increases:

  • The difference will be on the credit side
  • This will be debited to the income statement as an expense

• If the provision for doubtful debts decreases:

  • The difference will be on the debit side
  • This will be credited to the income statement as an income

How does a provision for doubtful debts affect the financial statements?

• At the end of a financial period, the balance from the provision for doubtful debts account appears on the statement of financial position

  • It is listed under trade receivables
  • The balance is subtracted from the balance for trade receivables

• The difference in the provision between the start of the year and the end of the year appears on the income statement

  • If the provision has increased, it appears with the other expenses
  • If the provision has decreased, it appears with the other income

Exam Hint When a provision for doubtful debts is first created, the whole amount is charged as an expense to the income statement, this is because the provision has increased from $0.

Worked Example Ricardo keeps a provision for doubtful debts at a rate of 3% of trade receivables. On 1 March 2023, the balance of the provision for doubtful debts was $1 530. On 29 February 2024, the trade receivables were $49 500, of which $1 000 should be written off as irrecoverable debts.

(a) Prepare the provision for doubtful debts account for Ricardo. Balance the account on 29 February 2024 and bring down the balance on 1 March 2024.

(b) State how the provision for doubtful debts affects the profit for the year ended 29 February 2024.

Answer:

• Subtract the irrecoverable debts from the trade receivables

$49 500 - $1 000 = $48 500

• Calculate the new provision for doubtful debts

3% × $48 500 = 1 455

• Calculate the change in the provision

$1 530 - $1 455 = $75

(a)

Enter the details into the provision for doubtful debts account

• Remember, the balance b/d is on the credit side

Final answer: Ricardo Provision for Doubtful Debts Account

Final answer: Date	Final answer: Details	Final answer: $**	Final answer: Date	Final answer: Details	Final answer: $
Final answer: 2024 Final answer: Feb 29	Final answer: Income statement	Final answer: 75	Final answer: 2023 Final answer: Mar 1	Final answer: Balance b/d	Final answer: 1 530
Final answer: Feb 29	Final answer: Balance c/d	Final answer: 1 455
		Final answer: 1 530			Final answer: 1 530
			Final answer: 2024 Final answer: Feb 29	Final answer: Balance b/d	Final answer: 1 455

**(b)

The provision for doubtful debts has decreased. This will be credited to the income statement and treated as an income.

Final answer: The provision for doubtful debts increases the profit for the year by $75