Definition
Provision for Bad Debts, also known as Allowance for Doubtful Accounts, is an accounting measure used to anticipate and account for debts that are unlikely to be paid by customers. It ensures that the financial statements reflect a realistic view of the likely recoverable amounts. This provision is recorded during the accounting period in which the doubtful debts are identified.
General Provision refers to a non-specific percentage of total outstanding debtors that is set aside. For instance, a 2% of debtors may be considered uncollectable. This type does not qualify as a tax deduction.
Specific Provision refers to debts identified based on concrete documentary evidence indicating their uncollectability. Specific provisions are tax-deductible if proof is provided.
Provision for Doubtful Debts is similar to the allowance for doubtful accounts and is treated alike for tax purposes.
Examples
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General Provision Example:
- Company XYZ calculates that 2% of its total accounts receivable may remain uncollected. This is a general estimate made without identifying specific bad debts.
Accounts Receivable: $100,000 General Provision for Bad Debts (2%): $2,000 -
Specific Provision Example:
- Company ABC has a debtor, Company DEF, from whom a payment of $5,000 was expected. Following Company DEF’s bankruptcy, Company ABC identifies this specific amount as unlikely to be recovered, providing necessary documentary evidence.
Accounts Receivable: $100,000 Specific Provision for Bad Debts: $5,000
Frequently Asked Questions
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What is the primary purpose of the provision for bad debts?
- The primary purpose is to present a realistic picture of accounts receivable and ensure that financial statements adequately reflect the probable recoverable amount.
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Is it mandatory to create a provision for bad debts?
- While not legally mandatory, it is a prudent accounting practice to create a provision for bad debts to anticipate potential losses accurately.
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What’s the difference between general and specific provisions for bad debts?
- General provisions apply a standard percentage to total debtors, while specific provisions are for debts identified with concrete evidence of uncollectibility.
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Are general provisions for bad debts tax-deductible?
- No, general provisions are not tax-deductible. Only specific provisions backed by documentary evidence are deductible.
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How is the provision for bad debts recorded in financial statements?
- Provisions for bad debts are recorded in the expense section of the income statement and as a contra asset account to accounts receivable on the balance sheet.
Related Terms
- Accounts Receivable (AR): Money owed to a company by its customers.
- Contra Asset Account: An account that offsets the balance of a corresponding asset account.
- Expense Recognition Principle: An accounting principle that dictates expenses should be recognized in the same period as the revenues they help to generate.
- Receivables Turnover Ratio: A financial ratio that measures how efficiently a company collects its receivables.
Online References
- Investopedia: Allowance for Doubtful Accounts
- AccountingTools: Provision for Bad Debts
- Corporate Finance Institute: Accounts Receivable Aging
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- “Financial and Managerial Accounting” by Charles T. Horngren, Walter T. Harrison Jr., and M. Suzanne Oliver
- “Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
Accounting Basics: “Provision for Bad Debts” Fundamentals Quiz
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