Why do we credit old provision for doubtful debts?

asked Aug 19, 2014 7,840 views

I think your question is why while preparing Profit and Loss A/c, we credit old provision for doubtful debts to P & L A/c and debit the P & l A/c by actual bad debts for the year and provision for bad debts required for the next year. I hope I am understanding your question right.
First of all you must understand what is Provision for Bad Debts. At the end of any years there are some Debtors whom we made sales this year (let us assume 2013) may turn out to be bad debts (this means they don't pay up) in the next year. Since we made profit on those sales in the present year (2013) and any bad debts pertaining to these sales should be deducted from the profits of the same year (2013). To give effect to this we take out a portion of this year's (2013) profits and create Provision for Bad Debts which is carried forwarded to the next year (2014) so that when debtors of 2013 don't pay, we may adjust these bad debts against the Provision for Bad Debts brought forward from last year (2013). Journal entry for creating provision is given below. Let us assume an amount of Rs.5000.
Profit & Loss A/c (2013) Dr. 5000
To Provision for Bad Debts 5000
When you prepare the Trial Balance for 2014, the Provision for Bad Debts which you carried forward from 2013 will appear on the credit side of of Trial Balance and actual Bad Debts incurred during 2014 will appear on the debit side of Trial Balance. In the adjustments you will be told to create Provision for Bad Debts against the Debtors appearing in the Trial Balance of 2014. Let us assume actual bad debts to be Rs.4500 and Provision required for next year (2015) to be Rs.6500.
Now there are two ways to show it in the Profit and Loss A/c.
First Method: Credit the Old Provision (5000) to P & L A/c and Debit actual Bad Debts of Rs.4500 and Provision required for next year, Rs.6500 to the P & L A/c. Net effect of this is that P & L A/c of 2014 has been debited by Rs.6000. The reason for crediting old provision to P& L A/c and Debiting Actual Bad Debts to P & L A/c is to credit the excessive Provision made last year to this year's Profit (5000-4500=500). Provision for Bad Debts required for next year (Rs.6500) was to be in any case debited to P & L A/c.
Second Method: You debit the Actual Bad Debts (Rs.4500) to Provision for Bad Debts (Rs.5000) and also show the Provision required for the next year (Rs.6500) on the Debit side of the Provision for Bad Debts A/c. The balance figure on the Credit side of this Provision A/c is the amount by which this year's (2014) P & L A/c will be debited.
Bad Debts 4500 Amount b/f 5000
Balance c/f 6500 P & L A/c 6000
Total 11000 Total 11000
You will notice that even in the above treatment net debit to P & L A/c has been Rs.6000. I hope your doubt is clear. In case if you still have some doubt, please don't hesitate to ask again.

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answered Aug 20, 2014 by (3,971 points)
Margin, mark up and inventory turnover
dear sir my question is this:

why is a need for making provision against bad debts

and how to find the percentage of provision for bad debt

I will try to explain this with the help of an example: For example you are a trader.  In 2013 You buy goods worth Rs.30000 and sell them for Rs.50000.  On the last date of financial year, sundry debtors are worth Rs.5000.  You calculate profit as Rs.20000 (Rs.50000-Rs.30000).   Out of those debtors of Rs.5000,  Rs.500 become bad in 2014.   Now you have to answer one question.  Is this loss of Rs.500 belongs to 2013 or 2014?  Obviously this loss of Rs.500 belongs to 2013 because sales to these debtors were made in  2013.  This means genuinely profit of 2013 should be Rs.19500 (Rs.50000-Rs.30000-Rs.500).

With experience every businessman knows approximately what percentage of debtors become bad.  On the basis of their experience they estimate the amount of bad debts for the next year and make a provision in the present year's Profit & Loss A/c.  In this example, they will make a provision for bad debts @ 10% of sundery debtors in 2013 by passing the following entry:

P & L A/c                                      Dr.   500                                                                                                         To    Provision for Bad Debts                               500

Though practically the bad debts may be less or more than Rs.500.