How to Record Bad Debts and Adjustments in Final Accounts
Bad Debt is a key concept in accounting and commerce, often encountered when dealing with credit transactions. When a business sells goods or services on credit, there is an expectation that the customer will pay at a later date.
However, sometimes a portion of these debts becomes irrecoverable due to reasons such as the debtor's bankruptcy, financial troubles, or unwillingness to pay. This irrecoverable amount is known as bad debt and is treated as a loss in the business’s accounts.
In practical terms, debt refers to money borrowed that must be repaid, usually with interest. When a customer fails to settle such a debt, it is no longer expected to be collected and is written off as bad debt. Recognizing bad debts ensures that the financial statements reflect a true and fair view of the business’s financial position.
Bad debts can occur in various scenarios:
- When customers who bought goods or services on credit default on payment.
- If a loan recipient fails to repay their dues.
- If a court order directs payment but the liable party does not comply.
Types of Bad Debts are not rigidly classified, but businesses may face bad debts based on their model—whether they are traders, service providers, or lenders. Common causes include bankruptcy, fraud, or genuine financial hardship from debtors.
To mitigate the impact of bad debts, businesses create a Provision for Bad Debts (also called Allowance for Doubtful Accounts). This is an estimated amount, set aside based on past experiences of irrecoverable debts, which acts as a buffer for future potential losses. Provisions help match bad debt expenses to the period in which related sales occurred, aligning with accounting’s matching principle.
Meaning and Accounting Treatment of Bad Debt
Bad debt is recorded as an expense when it is deemed uncollectible. The standard journal entry is:
Credit: Accounts Receivable/Sundry Debtors Account
This entry increases expenses and reduces the list of receivables, reflecting a more realistic figure in the financial statements.
| Date | Particulars | Debit (₹) | Credit (₹) |
|---|---|---|---|
| 31-Mar | Bad Debts A/c Dr. To Sundry Debtors |
5,000 | 5,000 |
Example
Suppose a company has debtors totaling ₹1,50,000. Out of this, ₹5,000 is confirmed as irrecoverable. The journal entry to write off this amount is:
To Sundry Debtors ₹5,000
(Being bad debts written off)
In the Profit and Loss Account, ₹5,000 is recorded as an expense. In the Balance Sheet, the value of debtors is shown after deducting the bad debt, i.e., ₹1,45,000.
| Particulars | Amount (₹) |
|---|---|
| Sundry Debtors (closing) | 1,50,000 |
| Less: Bad Debts Written Off | (5,000) |
| Net Debtors (to be shown in Balance Sheet) | 1,45,000 |
Provision for Bad Debts
To estimate future bad debts, a business may create a provision. For example, if the closing balance of debtors is ₹2,00,000 and a 5% provision is to be made, then:
This provision is shown as a deduction from debtors in the balance sheet to represent the realistic recoverable amount.
| Basis | Bad Debts | Doubtful Debts | Provision for Bad Debts |
|---|---|---|---|
| Meaning | Amount confirmed as irrecoverable | Amount considered uncertain for recovery | Buffer for estimated bad debts |
| Entry | Debit Bad Debts A/c | No direct entry | Debit P&L, Credit Provision A/c |
| Balance Sheet | Deduct from Debtors | Not shown separately | Deduct from Debtors |
Important Formulas
| Formula | Explanation |
|---|---|
| Bad Debts = Total Debtors – Realisable Debtors | Amount written off as loss because it cannot be collected |
| Provision for Bad Debts = % Specified × Debtors | Estimate based on past trends |
Solving Commerce Problems: Step-by-Step Approach
- Identify the amount confirmed as bad debt from total debtors.
- Record the journal entry to write off bad debt.
- Adjust the expense in the Profit and Loss Account.
- Deduct the bad debt from Sundry Debtors in the Balance Sheet.
- If required, calculate and deduct Provision for Bad Debts based on a set percentage.
Key Principles and Applications
- Bad debts are an expense and reduce net profit.
- Provision for bad debts anticipates future losses and supports fair presentation of receivables.
- Writing off bad debts keeps financial statements realistic and transparent.
Explore More on Vedantu
Understanding and managing bad debts is crucial for accurate financial reporting and exam success in commerce. Ensure that you practice regular accounting problems, focus on the correct treatment in profit and loss accounts and balance sheets, and consult trusted resources on Vedantu for deeper understanding.
FAQs on Bad Debt Meaning, Examples, and Accounting Treatment
1. What is bad debt in simple words?
Bad debt is the amount of money that a business is unable to recover from its customers or debtors. It is written off as a loss in the books of accounts. For example, if a customer fails to pay back ₹10,000 owed to a business, that amount is treated as bad debt and adjusted accordingly in the financial statements.
2. Is bad debt an expense?
Yes, bad debt is considered an expense for the business. It is recorded on the debit side of the Profit & Loss Account as it represents a loss arising from credit sales which cannot be collected.
4. What is an example of bad debt?
A common example of bad debt is when a company sells goods worth ₹7,000 on credit and the customer is declared bankrupt, making it impossible to recover the money. The ₹7,000 is recognized as a bad debt and written off as an expense in the accounts.
5. What is the difference between bad debt and doubtful debt?
Bad debt is an amount confirmed as irrecoverable and written off, while doubtful debt refers to amounts that may not be collected in the future but are not yet confirmed as bad.
- Bad Debt: Written off as a loss.
- Doubtful Debt: Estimated to become bad; not written off immediately.
6. How does bad debt affect the balance sheet?
Bad debts are deducted from Sundry Debtors (Accounts Receivable) on the asset side of the balance sheet, reducing the net realizable value of debtors shown in the final accounts.
7. What is provision for bad debts?
Provision for bad debts is an estimated amount set aside to cover future expected bad debts. It is calculated as a percentage of closing debtors and helps businesses absorb possible losses in advance.
8. How are bad debts shown in the Profit & Loss Account?
Bad debts are shown on the debit side of the Profit & Loss Account as an expense. If a provision for bad debts is created, only the required increase in provision is shown as a new expense.
10. What is the formula for calculating provision for bad debts?
Provision for Bad Debts = Specified Percentage × Debtors Balance.
For example, if provision is to be made at 5% on debtors of ₹2,00,000:
Provision = 5% × ₹2,00,000 = ₹10,000.
11. How are bad debts and provision for bad debts adjusted in final accounts?
- Bad debts written off are shown as expense in the Profit & Loss Account and deducted from debtors in the Balance Sheet.
- Provision for bad debts is also deducted from debtors’ balance in the Balance Sheet, and any increase in provision is charged as an expense in Profit & Loss Account.
12. Why is it important to provide for bad debts?
Providing for bad debts ensures accurate profit calculation and presents a true and fair view of assets in the balance sheet. It helps prevent overstatement of income and assets due to uncollectible receivables.
