Setting Up and Accounting for Provision for Bad Debts

Every business that sells on credit knows one uncomfortable truth: not every customer will pay. Some debtors default due to insolvency, some simply vanish, and accountants can’t wait until it actually happens to record the loss. That’s where the provision for bad debts comes in. It lets a business anticipate likely losses on its debtors and reflect a realistic picture of profit and assets, well before any single customer has actually defaulted.

What is provision for bad debts? 🔗

A provision for bad debts is an estimated amount set aside out of current profits to cover debtors who are expected to become irrecoverable in the future. It is not a write-off of an actual loss. It is a forward-looking estimate, usually based on a fixed percentage of debtors, past collection experience, or an ageing analysis of outstanding invoices.

The provision is created by debiting the Profit and Loss Account and crediting the Provision for Bad and Doubtful Debts Account. On the balance sheet, this provision is deducted from sundry debtors, so the debtors figure that appears under current assets reflects what the business realistically expects to collect, not the gross amount billed to customers.

Why the provision exists: the logic of prudence 🔗

Accounting is built on the idea that profits should not be overstated. If a company shows debtors of ₹10,00,000 as fully collectible when experience suggests ₹40,000 to ₹50,000 of that will never be recovered, the balance sheet paints an inflated picture of the company’s financial health. The provision corrects this by matching the probable loss on credit sales with the revenue earned in the same accounting period, rather than dumping the entire loss into a future year when the debt is finally confirmed bad.

This is also why the provision is treated as a charge against profit rather than an appropriation of profit. A reserve, like a general reserve, is money voluntarily set aside from profits already earned. A provision, on the other hand, exists because of a known risk with an uncertain amount, and accounting rules require it to be accounted for before profit is even finalised.

How the accounting entries work 🔗

Creating the provision for the first time 🔗

When a provision for bad debts is created for the first time, the entry is straightforward:

The amount is usually a percentage of the closing debtors after deducting any actual bad debts already identified. For instance, if a business estimates that 5 per cent of its debtors may default, that percentage is applied to the debtors balance remaining after known write-offs.

Adjusting the provision in later years 🔗

From the second year onward, the treatment gets slightly more layered because three figures now interact: the opening provision brought forward, the actual bad debts written off during the year, and the new provision required at year-end. Any actual debts written off during the year are first debited to the Provision for Bad Debts Account instead of directly to the Profit and Loss Account. Once that’s done, the provision account is topped up or scaled down to reach the newly desired closing balance, and the resulting adjustment, whether an additional charge or a partial reversal, hits the Profit and Loss Account. This method ensures that the total charge to profit in any year properly reflects both the debts actually written off and the change in the estimated provision, rather than double-counting the loss.

Where the adjustment is given outside the trial balance in an exam or a set of accounts, the standard rule is to first deduct any further bad debts from debtors, then calculate the new provision on the reduced figure, and finally record the net effect in the Profit and Loss Account while the full provision amount is deducted from debtors on the assets side of the balance sheet. If the provision is already given inside the trial balance, it typically means the necessary Profit and Loss adjustment has already been accounted for, and it only needs to be shown once, on the balance sheet.

Where it appears in the balance sheet 🔗

The provision never sits on the liabilities side as a separate item, even though it originates from a credit entry. Instead, it is shown as a deduction from trade receivables on the assets side, so that debtors are reported at their expected realisable value.

For companies registered under the Companies Act, this presentation isn’t optional. Schedule III requires trade receivables to be shown net of allowances, along with an ageing schedule that breaks debtors into buckets based on how long they’ve been outstanding. This ageing disclosure gives readers of the balance sheet a clearer sense of collection risk than a single lump-sum debtors figure ever could.

A worked example 🔗

Suppose a firm’s trial balance shows Sundry Debtors of ₹2,00,000 and an existing Provision for Bad Debts of ₹8,000. During the year, ₹5,000 of debtors turn out to be genuinely irrecoverable, and the firm decides to maintain a fresh provision at 5 per cent of the remaining debtors.

The balance sheet would then show debtors of ₹1,95,000 less the new provision of ₹9,750, giving net debtors of ₹1,85,250. Notice that the firm doesn’t debit ₹5,000 and ₹9,750 separately to the Profit and Loss Account. The old provision of ₹8,000 already absorbs part of this cost, which is exactly why netting against the opening balance matters.

Provision for bad debts vs bad debts written off 🔗

Students often mix these two up, so it helps to see them side by side.

In short, a bad debt is a loss that has already happened. A provision is a cushion for losses that haven’t happened yet but probably will, based on past patterns. Businesses need both: one to record reality, and one to prepare for it.

How income tax law treats this provision 🔗

This is where classroom accounting and real-world tax rules diverge, and it’s worth knowing the difference. For most businesses, only actual bad debts written off in the books qualify for deduction under Section 36(1)(vii) of the Income Tax Act, 1961. A mere provision, however carefully calculated, is not allowed as a deduction against taxable income for an ordinary trading or manufacturing business, since the loss hasn’t crystallised yet.

Banks, certain financial institutions, and, since assessment year 2017-18, NBFCs are the exception. They are permitted a separate deduction for provisions for bad and doubtful debts under Section 36(1)(viia), subject to caps tied to their gross total income and rural advances. This concession exists because lenders routinely carry large volumes of doubtful advances and need a more realistic tax treatment of expected credit losses. For everyone else, the rule stays simple: only debts actually written off in the accounts, connected to the business, and already included in income can be claimed as a deduction. This is a useful distinction to remember for exams that test the difference between accounting treatment and tax treatment of the same transaction.

Common mistakes students make 🔗

A few errors show up repeatedly in exam answers and even in practice:

• Confusing provision with reserve: A provision is a charge against profit for a known risk; a reserve is an appropriation of already-earned profit.
• Forgetting the opening balance: Charging the full new provision to the Profit and Loss Account without adjusting for the provision already carried forward inflates the expense.
• Writing off bad debts directly to the Profit and Loss Account: Once a provision account exists, further bad debts during the year should route through it, not bypass it.
• Showing the provision as a liability: It always reduces debtors on the assets side; it is never shown separately among current liabilities.

Getting these right isn’t just about scoring marks. Businesses that misjudge their provision for doubtful debts end up either overstating receivables that will never be collected or understating profits unnecessarily, both of which distort decisions made by lenders, investors, and management.

What do you think? If a company keeps its provision for bad debts unrealistically low year after year to show higher profits, what does that say about the reliability of its balance sheet? And how might an investor spot this pattern before it becomes a problem?

References

1. https://www.financestrategists.com/accounting/bad-debts/provisions-bad-debts/
2. https://www.geeksforgeeks.org/accountancy/adjustment-of-provision-for-bad-and-doubtful-debts-in-final-accounts-financial-statements/
3. https://upload.indiacode.nic.in/schedulefile?aid=AC_CEN_22_29_00008_201318_1517807327856&rid=10
4. https://www.incometaxindia.gov.in/w/section-36-12
5. https://carajput.com/blog/deduction-for-bad-debts-explanation-of-section-361vii/
6. https://cleartax.in/s/accounts-receivables-balance-sheet