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Provision for Bad and Doubtful debts??

rishi (Student) (37 Points)

27 May 2010

is Provision for Bad and Doubtful Debts account a liability or an operating expense??

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CA Shantanu Goyal (Practicing CA) (122 Points)
Replied 27 May 2010

hi rishi

As per AS-29

" A provision is a liability which can be measured only by using a substantial degree of estimation."

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CA Shree Jain (Chartered Accountant) (1572 Points)
Replied 27 May 2010

Doubtful debts

Prudence is essential for an entity in the process of recording of its transactions. It is incumbent upon an entity to ensure that all the likely losses are provided for during the process of preparation of financial statements. The entity has to take a decision whether or not all the debtors are, in fact, realisable.

Qualitative analyses of the debtors have to be carried out to decide upon the extent of provision to be made. The Companies Act requires sundry debtors to be classified as outstanding for more than six months and other debtors. The debts more than six months could be sticky, unless the management perceives it the other way.

It is necessary for the management to discuss with the collection department, (by whichever name it is known) the reliability of its debtors and the need to make a suitable provision for the likely loss arising there-from.

The chances of recovery of each of the debt should be analysed and the likelihood of the debt turning bad should be considered.

The likelihood of the debts turning doubtful depends upon the following factors: inability to meet the deadlines for payments; piling up of receivables; a stroke of misfortune hitting the debtor (earthquake, fire accidents, etc); the debtors dodging the payments; cheques issued by them getting returned dishonoured; and customers starting to source requirements from others.

Based on these, the likelihood of debtors turning bad is to be estimated and a provision needs to be made to cover the loss. When a provision for doubtful debt is made at a certain percentage (as it is taught in class rooms) it does not indicate that all the debtors across the board would be paying less than 100 per cent.

Timing of provision

It is logical that the provision should be made in the same accounting period when the corresponding revenue is recognised going by the matching concept. Therefore, the provision should be made in the year in which the sale is recorded. In the event, debt turning doubtful subsequent to the date of balance-sheet, it is an adjusting event and needs to be provided for in the earlier period (AS 4).

If the debt turns doubtful after the audit is completed, it should be provided for in the year it comes to the knowledge of the entity. It does not become an extraordinary item or a prior period item (AS 5).

Provision for doubtful debts is a provision against a possible loss. Therefore, it should only be disclosed as a deduction from sundry debtors. It would not be a proper disclosure to disclose provision for doubtful debts under the head ‘Current liabilities and provisions’.

The format of balance-sheet also requires provision for doubtful debts to be deducted from sundry debtors and not under the head “Current liabilities and provisions”

Accounting entries

When the provision is created, the same should be charged to the profit and loss (P&L) account and credited to provision for doubtful debts account. Any debts turning bad should be set off against the provision. While a provision for doubtful debts exists, writing off the bad debts to the P&L account is not an acceptable accounting practice.

Bad debts are recorded by passing the entry

Bad debts A/c Dr

To Sundry debtors.

The debit balance in the bad debts account should be set off against the provision for doubtful debts by passing the entry:

Provision for doubtful debts A/c. Dr

To Bad debts.

Adequacy of the provision for the current year should be considered after the bad debts is debited to provision for doubtful debts. Any shortfall should be made up by debiting the P&L account to top up the provision for doubtful debts account.

Any provision for doubtful debts made in an earlier year and not required any more should be written back. This should be written back to the P&L account and not to the general reserve.

A provision is an accounting estimate and audit and assurance standard 18 dealing with audit of accounting estimates casts a responsibility upon the auditor to satisfy himself of the quantification of the provision and, of course, the need for the same.

Section 227 (1A) requires the auditor to ensure that the transactions represented merely by book entries are not prejudicial to the interests of the company or of the shareholders. This entry is a point to be looked into by the auditor.

The auditor should carry out scrutiny of the ledgers to observe if any debt is to be provided for. He should carry out analytical procedures to justify the provision made. Postponement of making a provision or making a provision not called for might vitiate true and fair view of the financial statements.

Perhaps a resolution passed by the audit committee would strengthen the situation. The auditor should document the facts of the case and arrive at the conclusion on adequacy of the provision. He would also do well to seek a management representation (AAS 11) in this regard

In case of any suits pending, the auditor should discuss the matter with the legal advisors to know the possible outcome of the pending litigation. He might as well refer the matter to an expert.

Bad debts

Writing off of bad debts should be supported by appropriate reasoning as to why the debt is written off as bad. The efforts put in by the management and the results there of need to be studied. Insolvency petition filed by the debtor, liquidation proceedings of the Company, death of a person, court rulings that the debt is not payable, etc should be considered by the auditor before giving his consent to the writing off of the debts.

Recovery of bad debts

Recovery of bad debts is neither a prior period item nor an extraordinary item. In the event of recovery of bad debts, the amount so recovered forms part of the income of the year in which it is recovered. It is to be credited to the profit and loss account in the normal course. Therefore, dividends can be declared out of such recovery of bad debts.

I-T Act

A provision made for doubtful debts is not deductible from profits and gains. Bad debts can be claimed as a deduction only upon the debt turning bad and proved to the satisfaction of the assessing officer. Following factors are to be considered:

The debt is genuine and is in the course of business;

That all the efforts are made to recover the debt; or

It would be futile to put efforts to recover the debt.