FINAL ACCOUNTS – PROVISION FOR DOUBTFUL DEBTS

FIRST TERM E-LEARNING NOTE

SUBJECT: FINANCIAL ACCOUNTING 

CLASS: SS 2

WEEK TWO

FINAL ACCOUNTS – PROVISION FOR DOUBTFUL DEBTS

PROVISION FOR DOUBTFUL DEBTS

Although a debt may not actually have become bad, there may be doubt as to whether it will be paid.  It would be misleading to include that debt as an asset in the balance sheet pretending that the amount is not in doubt.  On the other hand, since it has not yet become bad, it would be wrong to write it off.  A provision is therefore made to cover such doubtful debt.

Provision for doubtful debt is a mere estimate of the total debt that may not be collected from the debtor.  This estimated expense for bad debts which cannot be calculated with substantial accuracy is charged to the profit and loss account as an expense.

HOW TO CREATE AND MAINTAIN A PROVISION FOR DOUBTFUL DEBTS

When the provision for doubtful debt is first created;

Debit               Profit and Loss Account

Credit              Profit for doubtful debts Account

with the full amount of the provision

In the years that follow, the entries in the accounts will be for increases or decreases in the amounts required for the provision.

INCREASING THE PROSIVION FOR DOUBTFUL DEBTS

Debit               Profit and Loss Account

Credit              Profit for doubtful debts Account

with increases in the provision.

DECREASING THE PROVISION FOR DOUBTFUL DEBTS

Debit               Profit for doubtful debts Account

Credit              Profit and Loss Account

with decreases in the provision.

In all the instances (A-C) as described above, the provision for Doubtful Debts is deducted

from the Debtors in the Balance Sheet.

EVALUATION

1. Explain the following terms:

(a) Bad debts     (b) Provision for doubtful debts

2. List three types of provisions that could give rise to adjustments in the final accounts.

Illustration

Business starts on 1 January, 2002 and its financial year end is 31 December annually.  A table of the debtors, the bad debts written off and the estimated doubtful debts at the end of each year is now given.

Year to                                   Debtors at                  Bad debts                   Debts thought

31 December                          end of year                 written off                  at end of year

                                                (after bad debts         during the year          to be doubtful to

                                                written off)                                                     collect

                                                N                                 N                                 N

2002                                        6,000                           423                              120

2003                                        7,000                           510                              140

2004                                        8,000                           604                              155

2005                                        6,400                           610                              130

You are required to show for each of the year ended 31^st December……

(a)        Bad Debts Account

(b)        Provision for Doubtful Debts Account

(c)        Profit and Loss Account (extracts)

(d)       Balance Sheet (extracts)

Bad Debts

2002                                        N         2002                                        N

Dec. 31 Sundries                     423      Dec. 31 Profit and Loss          423

2003                                                    2003

Dec. 31  Sundries                    510      Dec. 31 Profit and Loss          510

2004                                                    2004

Dec. 31 Sundries                     604      Dec. 31 Profit and Loss          604

2005                                                    2005

Dec. 31 Sundries                     610      Dec. 31 Profit and Loss          610

Provision for Doubtful Debts

2002                                        N         2002                                        N

Dec. 31 Balance c/d                120      Dec. 31 Profit and Loss          120

2003                                                    2003

Dec. 31 Balance c/d                140      Jan 1 Balance b/d                    120

Dec 31 Profit and Loss             20

• 140

2004                                                    2004

Dec. 31  Balance c/d               155      Jan 1   Balance b/d                  140

Dec. 31 Profit and Loss            15

• 155

2005                                                    2005

Dec. 31 Profit and Loss            25      Jan. 1 Balance b/d                   155

“       “   Balance c/d                130

155                                                      155

Profit and Loss Account (extracts) for the year ended 31^st December

N                                                         N

2002    Bad Debts                   423

Provision for               120

Doubtful debts

2003    Bad Debts                   510

Increase in

Provision for

Doubtful debts                          20

2004    Bad Debts                   604

Increase in provision

For Doubtful debts       15

2005    Bad Debts                   610                  2005    Reduction in provision

for Doubtful Debts                 25

Balance Sheet (extracts) as at 31^st December

N                     N

2002                Debtors                       6,000

Less: Provision

For Doubtful Debts        120              5,880

2003                Debtors                       7,000

Less: Provision for

Doubtful Debts              140               6,860

2004                Debtors                       8,000

Less: Provision for

Doubtful Debts           155                 7,845

2005                Debtors                       6,400

Less: Provision for

Doubtful Debts              130               6,270

EVALUATION

1. Differentiate between provision for bad debts and provision for depreciation.
2. List two characteristics of provisions in financial accounting.

1. What is the purpose of a provision for doubtful debts in financial statements?

a) To account for any potential losses due to debt collection issues

b) To provide estimates of future sales revenue that may be uncollectible

c) To reduce the amount of taxable income for the period, minimizing tax liability

d) None of the above

2. Which of the following factors can lead to an increase in a company’s provision for doubtful debts?

a) An increase in customer bankruptcies or defaults on loans

b) A decline in overall economic conditions, resulting in lower sales revenue and higher delinquency rates

c) An improvement in technology that improves debt collection processes and reduces losses

d) All of the above

3. How can a company decrease its provision for doubtful debts?

a) By increasing its credit terms or offering discounts to customers, in order to reduce defaults on payments

b) By conducting more thorough credit checks on new customers, in order to identify potential debt collection risks

c) By investing in new technology that improves debt collection processes and minimizes losses

d) By taking legal action against any customers who fail to pay their debts in a timely manner

4. Which of the following accounting methods is typically used to calculate a provision for doubtful debts?

a) Direct write-off method

b) Percentage of receivables method

c) Allowance method

d) All of the above

5. Which of the following is NOT a recommended best practice for managing a company’s provision for doubtful debts?

a) Keeping detailed records and documentation on all debt collection activities, including any steps taken to recover outstanding balances

b) Regularly reviewing the status of individual accounts to identify any potential issues or risks

c) Communicating with customers who are experiencing financial difficulties, in order to help them find a workable solution

d) Applying stricter criteria for extending credit to new customers, in order to reduce overall exposure to risk and losses.

6. What is the definition of a provision for doubtful debts?

A provision for doubtful debts is an amount of money set aside by a company to account for potential losses due to debt collection issues, such as defaulting customers or poor economic conditions. This provision may be calculated using a variety of different accounting methods, depending on the specific needs of the company.

7. How can a company effectively manage its provision for doubtful debts?

There are several key strategies that can be used to effectively manage a company’s provision for doubtful debts, including keeping detailed records and documentation on all debt collection activities, regularly reviewing individual accounts to identify potential risks, communicating with customers who are experiencing financial difficulties, and applying stricter criteria for extending credit to new customers. Additionally, companies may consider investing in technology that improves debt collection processes and minimizes losses, or taking legal action against any customers who fail to pay their debts on time. Overall, effective management of a company’s provision for doubtful debts is essential for minimizing financial risks and protecting the interests

State five differences between cash discount and trade discount

1. Cash discount and trade discount are two different types of discounts offered to customers by businesses.

2. Cash discount is a type of incentive offered by businesses to encourage customers to pay early, while trade discount is provided as a cost reduction for purchasing large quantities or making bulk orders.

3. Cash discounts are typically calculated as a percentage of the invoice amount, while trade discounts are given as a fixed discount on the total purchase price.

4. Cash discounts are usually offered to customers who pay within a specific timeframe, such as 10 days or 30 days, while trade discounts may be offered to various types of customers, such as wholesalers or bulk buyers.

5. Cash discounts are typically offered by businesses to encourage early payment, while trade discounts can help businesses increase their sales volume and profitability by attracting more customers.

6. Other key differences between cash discount and trade discount include the types of businesses that qualify for each discount, as well as the criteria used to calculate and offer these discounts to customers.

GENERAL EVALUATION

• State five differences between cash discount and trade discount
• Identify any seven prime books of account and highlight the uses of each ofthem where necessary
• List five advantages of using the imprest system to record petty cash transactions
• Explain the following types of errors (a) omission (b) principle (c) commission (d) original entry (e) complete reversal of entry (f) compensating error
• Explain how the following items are treated in Profit and Loss Account and Balanc Sheet (a) provision for doubtful debts (b) bad debts recovered

READING ASSIGNMENT

Simplified and Amplified Financial Accounting Page 143-150

WEEKEND ASSIGNMENT

1. A decrease in the provision for doubtful debts results in _______

(a) an increase in net profit        (b) a decrease in gross profit     (c) an increase in gross profit     (d) a decrease in net profit

2. The term bad debts means debt ________

(a) recorded in a wrong account         (b) owed by an employee     (c) paid with fake currency     (d) that cannot be collected again from the debtor

3. The gross profit for a trading period is calculated as _________

(a) Net sales less net purchases    (b) Net sales less cost of sales    (c) Net sales less closing stock    (d) Net sales plus cost of goods sold

Use the information below to answer questions 4 and 5

N

Provision for bad debts                                   1,000 Cr

Bad Debts                                                          500 Dr

Debtors                                                         50,000 Dr

Additional bad debts to be written off          500

New provision for bad debts to stand at 5% of debtors.

4. In the balance sheet the net figure for debtors is ________

(a) N47,025        (b) N46,550       (c) N45,600        (d)  N43,225

5. The total amount of bad debts to be charged as expenses in the profit and Loss Account is _________

(a) N2,000          (b) N1,500        (c) N1,000       (d)  N500

THEORY

Mr. Okonkwo’s books of account shows the information for four years ended 31^st December, 2000.  The balance of debtors and bad debts were given for the four years.

                                                                        Debtors                                   Bad

                                                                        Balance                                   Debts

                                                                        N                                             N

31^st December, 1997                           40,000                                     2,000

31^st December, 1998                           30,000                                     1,000

31^st December, 1999                           50,000                                     2,500

31^st December, 2000                           60,000                                     3,000

Provision for doubtful debts brought forward at 1^st January, 1997 was N600.

Mr. Okonkwo makes provision for doubtful debts at the rate of 10% on total debtors outstanding after deducting bad debts for the period.

You are required to prepare the following accounts for the years ended 31^st December, 1997, 1998, 1999 and 2000.

(a)        Bad Debts Account

(b)        Provision for doubtful debts Account

(c)        Profit and Loss Account

(d)       Balance Sheet (extract)