Depreciation, Bad Debts and Provision for Doubtful Debts

Some of the typical items which find a place in the profit and loss

account of a firm are depreciation, bad debts and provisions. Enlisting

these items on the debit side of the account is indicative of creating a

charge on the profits of the firm for that period. If these items are not

accounted for in the revenue statement for a period, it would hamper

the true and fair view of the accounts. Let us study these concepts in

detail.

Depreciation

A charge on the value of fixed assets of a firm, depreciation usually

entails writing down the cost of a fixed asset. This is done in lieu of

the matching concept of accountancy. There are two main methods of

charging depreciation, which is the straight-line method and the

written down value method.

Bad Debts

Bad debts are those items of charge on the profits of the company that

indicate the sums of money that could not be recovered from a debtor,

during the year. In order to record the number of bad debts correctly,

such sum is charged to the profit and loss account and deducted from

the value of debtors for that year, so that the amount represents money

that is actually expected to accrue from the debtors.

The journal entry passed to record the event is as follows:

Bad Debt Exp —————Dr

To Receivable Account —————-Cr

Provision for Doubtful Debts

The provision for doubtful debts is an estimated amount of bad debts

that are likely to arise from the accounts receivable that have been

given but not yet collected from the debtors. It is similar to the

allowance for doubtful accounts.

Browse more Topics under Financial Statements

● An Introduction to Financial Statements

● Distinction between Capital Revenue and Capital Expenditure

● Operating Profit

● Trading and Profit and Loss Account

● Balance Sheet and Opening Entry

● Stakeholders and their Information Requirement

● Depreciation, Bad Debts and Provision for Bad and Doubtful

Debts

● Need for Adjustment, Closing Stock and Outstanding Expenses

● Prepaid Expenses, Accrued Income and Income Received in

Advanced

● Provision for Discount on Debtors, Managers Commission and

Interest on Capital

● Manufacturing Account

Such provision is provided for, under accrual basis accounting, so that

an expense is usually recognized for probable bad debts as soon as

invoices are issued to customers, instead of waiting several months to

find out exactly which invoices turned out to be stale.

Thus, the net impact of the provision for doubtful debts is to accelerate

the recognition of bad debts into earlier reporting periods. The journal

entry passed in this case will be as follows:

Provision for bad and doubtful debts A/c …. Dr

To Debtors A/c ………. Cr.

Solved Question for You

Q: ABC LTD has trade receivable of worth INR 50,000 as at 31

December 2010. XYZ LTD, a receivable owing INR 10,000 to ABC

LTD at the year end, has been recently been wound up. Consequently,

ABC LTD does not expect to recover the amount due from XYZ LTD.

Based on past experience, ABC LTD estimates that 5% of its

receivables will default. An allowance for doubtful debts on 31

December 2009 appeared at INR 1500. ABC LTD must write off the

INR 10,000 receivable from XYZ LTD as bad debt. Provide journal

entries to record the events.

Answer: The journal entries will be as follows

Bad debt A/c – Dr. 10,000

To XYZ Ltd. 10,000

Allowance for doubtful debts A/c – Dr. 500

To Profit & Loss A/c 500

Need for Adjustment, Closing Stock and Outstanding Expenses

When the final accounts of a firm are being finalized, necessary

adjustment entries need to be incorporated at the close of the year, in

order to prepare correct accounts. Without passing such adjustment

entries, the correct value of the profit and loss for the year cannot be

correctly determined. Hence, adjustment entries play a pivotal role

while preparing the balance sheet at the end of the year. Let us

understand more about closing stock and outstanding expenses.

Adjustment of Closing Stock in the Final Accounts

The closing stock implies inventory held at the end of the year. Thus,

to derive information relating to closing stock we maintain a real

account by name Closing Stock. It provides data relating to the value

of stock unsold at the end of the accounting period. The value of

closing stock is ascertained by physical verification of stock and its

valuation at cost or market price whichever is lower.

Usually, the closing stock does not appear in the Trial Balance when

the accounts are being finalized as the closing stock is ascertained by

physical verification, which takes time in bringing up the value. Thus

it appears as part of adjustment entry, which has to be passed before

the preparation of Final Accounts.

If the closing stock is shown in the trial balance it means the

adjustment for the closing stock has already been done and it will be

shown as a current asset on the right side of the balance sheet. From

the accounting point of view, aspects covered while preparing the

accounts are:

1. Closing Stocks as shown on the Credit Side of Trading

Account

2. Closing Stocks as shown on the Asset Side of Balance Sheet

However, if the value of the adjusted purchase(the cost of goods sold)

is given then, the trial balance will show figures of both adjusted

purchases account and Closing Stock Account.

Browse more Topics under Financial Statements

● An Introduction to Financial Statements

● Distinction between Capital Revenue and Capital Expenditure

● Operating Profit

● Trading and Profit and Loss Account

● Balance Sheet and Opening Entry

● Stakeholders and their Information Requirement

● Depreciation, Bad Debts and Provision for Bad and Doubtful

Debts

● Prepaid Expenses, Accrued Income and Income Received in

Advanced

● Provision for Discount on Debtors, Managers Commission and

Interest on Capital

● Manufacturing Account

Adjustment Entries for Outstanding Expenses

There are certain expenses which are incurred but not actually paid.

They are called outstanding expenses. Expenses like salaries, rents and

more, of each month, are paid in the following months. Such

expenses, which are due for payment in a given accounting year but

the payment will be made in the future accounting year, that is, the

payment of such items is postponed, are Outstanding expenses.

In order to bring a true view of the accounts, it is necessary to account

the expenses in that year in which they occur, irrespective of the fact

whether they are paid or not. That is, all such outstanding expenses

which are in nature of a liability account must be recorded in the

accounting period if they relate to that accounting year. The

accounting effect of this entry is as follows:

1. An outstanding expense is a liability and shown in Balance

Sheet as a liability.

2. An outstanding expense is added to the respective expense in

profit and loss account.

Solved Example for You

Question: Pass journal entries for the following events:

1. Trial Balance shows Salary of Rs 15,000 but the salary of Rs

1,000 for the month of December 2004 has not been paid till

31.12.2004.

2. The value of the closing stocks is Rs 10,000

Answer:

Outstanding Salary A/c Dr 1000

To Cash A/c 1000

Closing Stock A/c Dr 10000

To Trading A/c 10000

Prepaid Expenses, Accrued Income and Income Received in Advanced

As we know that accounting is done on the basis of the Accrual

concept. As per this concept, we not only record the transactions that

are in cash only but also those which relate to the accounting year

whether in cash or not. In order to determine the correct profit and loss

and the true and fair financial position at the end of the year, we need

to account for all the expenses and incomes pertaining to the current

accounting year. Thus, Outstanding Expenses, Prepaid Expenses,

Accrued Income and Income Received In Advance require

adjustment.

Outstanding Expenses

Sometimes in the normal course of business, an enterprise may have

some expenses relating to which the payment is due at the end of the

year. We know these expenses as Outstanding Expenses.

Wages, salary, rent, interest on the loan, etc. are examples of such

expenses that may remain due at the end of the accounting year.

However, we need to record them as they relate to the incomes of the

current year. Like all other expenses, they are also a charge against the

profit of the current year.

Browse more Topics under Financial Statements

● An Introduction to Financial Statements

● Distinction between Capital Revenue and Capital Expenditure

● Operating Profit

● Trading and Profit and Loss Account

● Balance Sheet and Opening Entry

● Stakeholders and their Information Requirement

● Depreciation, Bad Debts and Provision for Bad and Doubtful

Debts

● Need for Adjustment, Closing Stock and Outstanding Expenses

● Provision for Discount on Debtors, Managers Commission and

Interest on Capital

● Manufacturing Account

The Journal entry to record outstanding expenses is:

Date Particulars Amount (Dr.) Amount (Cr.)

Expense A/c Dr.

To Outstanding Expense A/c

(Being recording the expense for the current year outstanding)

The Outstanding Expense A/c appears on the liability side of the

Balance Sheet. While preparing the Trading and Profit and Loss A/c

we need to add the amount of outstanding expense to that particular

expense.

Prepaid Expenses

In the normal course of business, some of the expenses may be paid in

advance. However, the organization may not receive the benefits from

these expenses by the end of the current accounting year. We call

these expenses as prepaid expenses. We treat them as current assets.

The Journal entry to record prepaid expenses is:

Date Particulars Amount (Dr.) Amount (Cr.)

Prepaid Expense A/c Dr.

To Expense A/c

(Being prepaid expense recorded)

The Prepaid Expense A/c appears on the assets side of the Balance

Sheet. While preparing the Trading and Profit and Loss A/c we need

to deduct the amount of prepaid expense from that particular expense.

Accrued Income

It may so happen that we may earn some incomes during the current

accounting year but not receive them in the same year. Such income is

accrued income.

Thus, these incomes pertain to the current accounting year. Therefore,

we need to record them as current year’s incomes.

The Journal entry to record accrued incomes is:

Date Particulars Amount (Dr.) Amount (Cr.)

Accrued Income A/c Dr.

To Income A/c

(Being recording of accrued incomes)

The Accrued Income A/c appears on the assets side of the Balance

Sheet. While preparing the Trading and Profit and Loss A/c we need

to add the amount of accrued income to that particular income.

Income Received in Advance

In the ordinary course of a business, it may receive some incomes in

advance in spite of not rendering the services. Such incomes are

incomes received in advance.

Thus, these are not pertaining to the current accounting year.

Therefore, these are current liabilities.

The Journal entry to record income received in advance is:

Date Particulars Amount (Dr.) Amount (Cr.)

Income A/c Dr.

To Income Received in Advance A/c

(Being income received in advance recorded)

The Income Received in Advance A/c appears on the liabilities side of

the Balance Sheet. While preparing the Trading and Profit and Loss

A/c we need to deduct the amount of income received in advance from

that particular income.

Solved Example For You

From the following information pass the necessary journal entries

relating to the items of expenses and incomes. Also, show their

treatment in the Trading and Profit and Loss A/c and the Balance

Sheet.

1. Interest on loan expenses ₹150000. The interest of ₹50000 is

outstanding.

2. Wages expense ₹72000. Out of this wages of ₹12000 pertains

to the next accounting year.

3. The commission received ₹15000. Amount of commission

earned but not received is ₹5000.

4. Rent received ₹50000. Rent of ₹10000 is received in advance.

Ans.

Journal Entries

Date Particulars Amount (Dr.) Amount (Cr.)

1. Interest on Loan A/c Dr. 50000

To Outstanding Interest on Loan A/c 50000

(Being recording the interest on a loan for the current year outstanding)

2. Prepaid Wages A/c Dr. 12000

To Wages A/c 12000

(Being prepaid wages recorded)

3. Accrued Commission A/c Dr. 5000

To Commission A/c 5000

(Being recording of accrued commission)

4. Rent A/c Dr. 10000

To Rent Received in Advance A/c 10000

(Being rent received in advance recorded)

Trading and Profit and Loss A/c (extract)

For the year ending….

Particulars Amount (Dr.) Particulars Amount

(Cr.)

To Opening Stock A/c By Sales A/c

To Purchases A/c By Closing Stock A/c

To Wages A/c 72000

Less: Prepaid wages (12000) 60000

To Gross Profit c/d

xxx xxx

To Interest on Loan A/c 150000 By Gross Profit b/d

Add: Outstanding interest on a loan

50000 200000 By Commission A/c 1500

0

Add: Accrued commission 5000 20000

By Rent A/c 50000

Less: Rent received in advance

(10000)

To Net Profit

xxx xxx

Balance Sheet

As at …

Liabilities Amount Assets Amount

Capital Fixed Assets:

Add: Net Profit Land and Building

Less: Drawings Plant and Machinery

Long-term liabilities: Furniture and Fixtures

Bank Loan Current Assets:

Current Liabilities: Stock

Outstanding Interest on Loan 50000 Debtors

Rent received in advance 10000 Prepaid Wages 12000

Accrued Commission 5000

xxx xxx

Provision for Discount on Debtors, Managers Commission and Interest on Capital

All items of adjustments that require incorporation in the accounts,

need to be adjusted at the right place so that the correct value of items

can be deciphered. Without such incorporation, it will be difficult to

judge the right amount of profit or loss earned and incurred during a

period and the value of assets and liabilities that should appear in the

accounts. Let us take a look at the items of Provision for Discount on

Debtors, Managers Commission and Interest on Capital that impact

the accounts of a firm.

Adjustments Related to Provision for Discount on Debtors

In accounting terms, provision for discount on debtors shows the

reserve amount for adjusting loss due to discount allowed to debtors.

In order to receive payment faster from their customers, businessman

provides a discount to those customers who pay before maturity of the

debt.

So, at the end of the year, we make provision for next year losses due

to discount allowed. Thus, this provision will be known as provision

for discount on debtors. The provision is made on the basis of past

experience with customers. If the Debtors of the current period settle

their accounts promptly in the succeeding period, a discount will have

to be allowed by the firm.

The amount of discount is an expected loss and a provision has to be

made for it in the Final Accounts relating to the current year. Thus, the

discount that might be allowed on debts whose debts fall in the

succeeding year is estimated.

Browse more Topics under Financial Statements

● An Introduction to Financial Statements

● Distinction between Capital Revenue and Capital Expenditure

● Operating Profit

● Trading and Profit and Loss Account

● Balance Sheet and Opening Entry

● Stakeholders and their Information Requirement

● Depreciation, Bad Debts and Provision for Bad and Doubtful

Debts

● Need for Adjustment, Closing Stock and Outstanding Expenses

● Prepaid Expenses, Accrued Income and Income Received in

Advanced

● Manufacturing Account

It is shown on the debit side of Profit and Loss Account and as the

deduction from Debtors in Balance Sheet. But always note that the

amount of Provision is calculated only after deducting the amount of

additional Bad Debts. Entry related to such an event is recorded as

follows:

Profit and loss A/c Dr xxx

To Provision for discount on debtors A/c xxx

Adjustments Related to Manager’s Commission

Companies often may have to offer a fixed percentage of their net

profit to managers in the form of commission. This is done to motivate

and encourage them to generate more revenue for the company.

Accounting treatment related to such an event is as follows:

Manager’s commission is shown as a payable since it is calculated at

the very end:

Manager’s Commission A/c Dr xxx

To outstanding Commission A/c xxx

While paying off the commission:

Outstanding commission A/c Dr xxx

To bank A/c xxx

For transferring the expense to revenue statement:

Profit and Loss A/c Dr xxx

To Manager’s Commission A/c xxx

Adjustments Related to Interest on Capital

In order to deduce a true picture of the business’ profit earning

capability, it is a common trend to charge interest on capital. Journal

entry for interest on capital includes two accounts, Capital Account &

Interest on Capital Account.

Interest on capital is an expense for the firm and therefore, it is added

to the capital of the proprietor thus, increasing his total capital in the

business. Further, it is not paid in cash or by the bank. Related

accounting entry for recording such interest is as follows:

Interest on capital A/c Dr xxx

To Capital A/c xxx

Solved Example for You

Question: Record the following events through a journal entry:

Provide 10% interest on capital at the end of the year to X when his

contribution to the business is 1, 00,000.

Answer:

Interest on capital A/c Dr 10000

To Capital A/c 10000