All debtors are good- Partnership Adjustments Part 10

Introduction

In this article we will learn about the adjustment for 'All debtors are good' in partnership accounts.

Please note that the adjustment will be done in a similar manner whether you are doing admission, retirement, death or change in profit ratio question. You need not understand the adjustments separately for these chapters.

Let's first understand the meaning of bad debts. Then we will understand the meaning of provision for bad debts. Finally we will understand the adjustment of "All Debtors are good".

Meaning of Bad Debts

So what are bad debts. Lets first Understand this in step by step manner to understand the adjustment better.

• A partnership firm is formed to do business and earn profits . The firm earns profits when it makes sales of either goods or services.
• The sales can be made either in cash or on credit. Cash Sales means that the purchaser will make the payment immediately. Credit sales means that the purchaser will make the payment after some days like for example after 2 months.
• When a firm makes credit sales then this is recorded as a debtor in the books of accounts. Firm makes credit sales to many people. The sum of amount of all the debtors is called Sundry Debtors.
• Some of the people who are debtors for the firm, may not make the payment even after the agreed time. The firm will incur a loss due to this. In other words, the debtors have become bad and hence called bad debts.
• Bad Debt is a loss for the firm. This is charged to the profit and loss account. It is shown on the debit side of profit and loss account.

In all the above examples of creating a liability that we have seen above two key observations come out. First , expenses are increased and hence debited. Second, liability is increased and hence credited. The expense account is closed at year end by transferring to profit and loss account for the year. The liability account is shown in balance sheet every year till it is paid.

Meaning of Provision for Bad Debts

Now we have understood the meaning of bad debts. Let's move to understanding the meaning of provision for bad debts.

As we have seen earlier, a firm makes sales both against cash and against credit. This is true for most types of businesses. If a business will make credit sales, then there are always high chances that, there will be some debtors who will not pay money and the debt will become bad. Bad debts are inevitable for any business which makes credit sales.

When a business makes credit sales, then it is expected, that some percentage of debtors will become bad. Based on past experience, every business can know, approximately what percentage of their debtors become bad debts. Thus bad Debts are inevitable.

Due to conservatism principle (explained below), the business should account immediately for this expected loss. When a business account for expected bad debts likely to occur in future, then it is known as provision for bad debts.

Please note that such expected loss due to bad debts, may or may not happen in future. We are just accounting based on expectation and estimates. If the expected loss does not happen in future then we will reverse the provision

Conservatism Principle

• Conservatism principle states that all losses and expenses, expected to occur in future, should be accounted for in books of accounts immediately. A question arises How to account for some expense which may happen in future? The answer is, the business will estimate the expected loss or expense that may happen, and make a provision for it in books of accounts. Thus this principle requires accountants to remain prudent while declaring the profits of the business. This is also known as prudence concept.

What is provision in Accounting or Why is it called provision

Why is it called provision? Provision means to set aside funds for some purpose. There can be various types of provisions created in books of accounts.

Here we are discussing about provision for bad debts which means setting aside funds for meeting expected bad debts in future.

Provision for bad debts journal entry

Lets now discuss the journal entry made for provision for bad debts.

• Bad Debts A/c Dr..
  • To Provision for Bad Debts A/c
• Bad debts are an expense which are increasing and hence debited.
• Provision for bad debts is in the nature of a liability which is increasing and hence credited.

At the end of the year Bad Debts account which is an expense will be closed by transferring to profit and loss account. Journal entry will be

• Profit and Loss A/c Dr..
  • To Bad Debts A/c

Provision for bad debts account, which is in the nature of a liability, will continue to be shown in the balance sheet. It remains in balance sheet, till the bad debts actually happen, or else the provision for bad debts is reversed.

All debtors are good adjustment given in question

Now that we have understood the meaning of provision for bad debts, lets come to how 'All Debtors are good' adjustments are given in the question. Let's take an example to understand this. A balance sheet will be given in the question.

The additional information below the question says that "All Debtors are Good".

All debtors are good - Understanding the adjustment

Next we come to understanding the adjustment. In the past, we made a provision for bad debts of Rs 40000 which is appearing in the balance sheet. As per the question, all debtors are good. It means there is no need for provision for bad debts now.

So we will reverse the provision created earlier. Since bad debts was a loss booked earlier, but will not happen now, so there will be a revaluation gain.

All Debtors are good journal entry

• Provision for Bad Debts A/c Dr.. 40000
  • To Revaluation A/c 40000

Provision for bad debts account is to be reversed. It is in the nature of liability. Since it is reversed, so there is decrease in liability. Hence Provision for bad debts account gets debited.

Secondly, an expected loss booked in books of accounts in some earlier financial year is now reversed. So there is revaluation gain. Revaluation account gets credited.

All debtors are good entry in Revaluation Account

Since there is a profit, so it will be shown on credit side of revaluation account. On the credit side of revaluation account we will write, 'By Provision for bad debts'.

There will be no entry on the debit side of revaluation account

All debtors are good in Partner Capital A/c

There will be no impact in partner capital account as we have not passed any entry in partner capital account

All debtors are good in Balance Sheet

Next we will discuss how this adjustment will be shown in the balance sheet. In the balance sheet the value of provision for bad debts will become nil as it is reversed. The Sundry Debtors will appear in the balance sheet at its full value of Rs 100000.

There will be no impact on the liabilities side of the balance sheet.

Finally

Here is the summary of the whole adjustment.

That's all for this adjustment. Please go through below links for more partnership accounts adjustments on reconstitution.

Partnership Accounts Index