Describe the necessary adjustments needed in the preparation of financial statements (depreciation, bad debts and doubtful debts)

Meaning

Depreciation is the portion of a non-current asset's cost that is consumed during its useful life. Because assets like vehicles, machinery, and equipment wear out or become outdated over time, their value must be reduced in the accounting records each year.

Causes of Depreciation

• Physical deterioration — wear and tear from use, rust, rot, or decay
• Obsolescence — the asset becomes outdated due to new technology
• Inadequacy — the asset is too small for a growing business
• Depletion — natural resources (like a quarry) are used up over time
• Time — some assets (like patents or leases) lose value simply with the passage of time

Methods of Calculating Depreciation

Straight-Line Method

This method spreads the cost of the asset evenly over its useful life.

$\text{Annual Depreciation} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}$

Example: A bakery in Mwanza purchases a dough mixer for Tshs 1,200,000. It is expected to last 5 years with a salvage value of Tshs 200,000.

$\text{Annual Depreciation} = \frac{1,200,000 - 200,000}{5} = \frac{1,000,000}{5} = \text{Tshs 200,000 per year}$

Reducing Balance Method

A fixed percentage is applied to the book value (cost minus accumulated depreciation) each year. The depreciation amount decreases over time.

Example: A delivery van costs Tshs 1,000,000. Depreciation is charged at 20% per year on the book value.

Recording Depreciation

Depreciation is recorded as an expense in the Profit and Loss Account. The corresponding credit goes to a Provision for Depreciation or Accumulated Depreciation account (a contra-asset account).

Journal Entry:

• Debit: Profit and Loss Account (Depreciation Expense)
• Credit: Provision for Depreciation / Accumulated Depreciation

In the Balance Sheet, the asset appears at its net book value (cost minus accumulated depreciation).

Meaning

A bad debt is an amount owed by a customer that the business estimates will never be collected. It arises when a debtor fails to pay, even after repeated reminders.

Direct Write-Off Method

Under this method, bad debts are only recorded when a specific debt is confirmed as uncollectible.

Example: Mlimani Electronics sold goods on credit to Juma for Tshs 150,000. At the end of the year, Juma's debt is confirmed as uncollectible.

Entries:

1. Write off the debt:

   • Debit: Bad Debts Account — Tshs 150,000
   • Credit: Debtors (Juma's Account) — Tshs 150,000

2. Transfer to Profit and Loss:

   • Debit: Profit and Loss Account — Tshs 150,000
   • Credit: Bad Debts Account — Tshs 150,000

Limitations

The direct write-off method violates the matching principle because the expense is recorded long after the related sale was made. For this reason, businesses often use the allowance method for doubtful debts instead.

Meaning

A provision for doubtful debts is an estimate of debts that may not be collected in the future. Unlike bad debts (which are specific), this is a general provision based on a percentage of total debtors.

Why It Is Needed

The allowance method ensures that:

• Expenses are matched with the revenue they relate to (matching principle)
• The Balance Sheet shows debtors at their realizable value — the amount expected to be actually received

How to Record

1. Year 1 — Creating the provision:

   • Debit: Profit and Loss Account (with the estimated amount)
   • Credit: Provision for Doubtful Debts

2. Year 2 and onwards:

   • Adjust the provision. If the required provision is greater than the existing balance, increase it. If it is smaller, decrease it.

Example: On 31 December 2022, the total debtors of a shop in Dar es Salaam were Tshs 2,000,000. The business decides to make a provision for doubtful debts at 5%.

Required provision = 5% × 2,000,000 = Tshs 100,000

Entry:

• Debit: Profit and Loss Account — Tshs 100,000
• Credit: Provision for Doubtful Debts — Tshs 100,000

In the Balance Sheet, debtors are shown as:

Bad Debts Recovered

When a debt previously written off is later paid, it is called a bad debt recovered. The amount is treated as income.

Entry to reinstate the debtor:

• Debit: Debtor's Account
• Credit: Bad Debts Recovered Account

Entry when cash is received:

• Debit: Cash/Bank
• Credit: Debtor's Account

Entry to close the recovery account:

• Debit: Bad Debts Recovered Account
• Credit: Profit and Loss Account

The following information relates to Hamisi's General Store for the year ended 31 December 2023:

• Total debtors at year end: Tshs 800,000
• During the year, a debtor named Rajabu was declared bankrupt; his debt of Tshs 30,000 is to be written off as bad
• The business maintains a provision for doubtful debts at 5% of debtors

Required:

1. Show the bad debts account
2. Show the provision for doubtful debts account
3. Extract how debtors will appear in the Balance Sheet

Solution:

1. Bad Debts Account

2. Provision for Doubtful Debts Account

3. Balance Sheet Extract (Debtors)

In Tanzania, small business owners such as shopkeepers in Kariakoo or food vendors at Mlimani City often sell goods on credit to regular customers. At the end of the year, they must account for the possibility that some customers may not pay. By recording depreciation on their motorbikes or storage equipment and making provisions for doubtful debts, they prepare accurate financial statements that help them plan for taxes, apply for loans from banks like CRDB or NMB, and make better business decisions for the coming year.