2Bad debtsWhen a business sells to a customer on credit it takes a business risk that the customer might not pay the amount owed.A business might have to write off the debt as a bad debt.Bad debts are an expense and will reduce the profit of the business.A business may decide that the debtor cannot pay or the cost of chasing the debt is not cost effective. The debt will then be written out of the ledger.
3How can a business prevent bad debts for new customers? Cash sales or cash on deliveryTrade referencesCredit referencesBank referencesSet a credit limitEarly settlement dates
4How can a business prevent bad debts for existing customers? Send regular statements to debtorsFollow up letterReminder letter with the threat of taking legal actionUsing a third party such as a debt collectorTake legal action in the civil courtsA business could also consider using a factoring firm. The factoring firm would pay the business cash for a proportion of the debtors. The business would not have the problem of chasing debtors for payment.
5Accounting entries Debit - bad debts account Credit - personal account of the debtorJohn GreenBal b\d 6, Bad debts 6,000Bad debts accountJohn Green 6, Profit and loss a\c 6,000
6Accounting entriesA debtor may agree to pay some of the debt and the firm will write off the remainder of the debt.John Davy a debtor owes £5,000 and agrees to pay 40 pence in the £. The remainder of his debt will be written off. The following journal entries would be made:JournalDr Cr£ £Bad debts ,000John Davy ,000Bank ,000John Davy ,000
7Provision for bad and doubtful debts A business should make an estimate of the amount of debt that might not be recovered. The accountant will create a provision for doubtful debts in the ledger.When creating a provision the concept of prudence is applied. The profit of the business will not be overstated. Debtors will be shown at a true and fair value in the balance sheet.
8when creating a provision Factors to considerwhen creating a provisionCustomer historyType of customerSize of the debtGeographical position of the debtorInterest ratesGeneral economic factorsExpert knowledge of the business sector
9when creating a provision Factors to considerwhen creating a provisionIt is common practice for a business to produce an analysis of debtors called an aged debtor analysis.This shows the amount of time debts have been outstanding.A business will adopt a practical approach by taking a fixed percentage of debtors. For example the accountants estimate that 5% of the debtors could be bad.Total debtors £500,0005% Provision £25,000The accountants estimate that the asset of debtors is £475,000.
10The accounting entries to create a provision for doubtful debts Debit - profit and loss accountCredit - provision for doubtful debts accountWith the full amount of the provisionTotal debtors £500,0005% provisionProvision for doubtful debts accountBal c\d , Profit and loss 25,00025, ,000Bal b\d ,000
11Provision for doubtful debts Debtors must be shown in the balance sheet at the net figure.Balance sheet extractCurrent assetsDebtors ,000Less provision for doubtful debts , ,000The prudence concept has been applied and the debtors’ figure is not overstated.
12The accounting entries to increase the provision The accountant may decide that the provision is not enough and must be increased:Debit profit and loss accountCredit provision for doubtful debts accountonly with the amount of the increaseIf the total debtors have increased to £800,000 and the business maintains a 5% provision on debtors:
13Provision for doubtful debts account Entries to increase the provisionProvision for doubtful debts accountBal c\d 40,000 Bal b/d ,000Profit and Loss 15,00040, ,000Bal b/d 40,000Current assetsDebtors ,000Provision for doubtful debts 40, ,000
14Entries to reduce the provision The accountant may decide that the provision is too high and will need to be reduced.Debit provision for doubtful debts accountCredit - profit and loss accountonly with the amount of the reduction.This will increase the profit. The amount of the reduction should be added to the gross profit in the trading and profit and loss accounts.If the total debtors reduced to £600,000 and a 5% provision is maintained:
15Provision for doubtful debts account Entries to reduce the provisionProvision for doubtful debts accountProfit and Loss 10,000 Bal b/d ,000Bal c/d 30, , ,000Bal b/d 30,000Current assetsDebtors ,000Provision for doubtful debts 30, ,000
16Aged debtors analysisA business can produce an analysis of the age of debtors in the business. It can then use the analysis to decide upon:The amount of bad debts to be written offThe amount of the provisionAS students may be required to use the aged debtors analysis in the exam to calculate the amount of bad debts and the provision for doubtful debts.
17Aged debtors schedule Example: Age of the debt Total debtors £ Up to 30 days ,00031 to 60 days ,00061 to 90 days ,000Over 90 days ,000
18Aged debtors analysis Policy: Age of the debt Amount of provision (%) Up to 30 days Nil31 to 60 days61 to 90 daysOver 90 days
19Aged debtors analysis Calculation: Age of the debt Amount % Provision Up to 30 days 20,31 to 60 days 18,61 to 90 days 15, ,500Over 90 days 6, ,200Total of provision ,600