Irrecoverable debt and allowance for doubtful debt Amjid Malik

explain the difference between Aim: To explain the period-end adjustments for irrecoverable debts and doubtful debts. Objectives: You should be able to explain the difference between irrecoverable debts (bad debt) written off allowance for doubtful debts record irrecoverable debts (bad debt) and doubtful debts in ledger a/c’s and in ETB disclose trade receivables (trade debtors) in a statement of financial position (balance sheet) net of the doubtful debt allowance.

Credit sales & Irrecoverable debt When sales are made to credit customers they are recognised as income when the invoice is sent out on the assumption that the money due will eventually be received from the customer/receivable. The double entry to record the credit sale is: Dr. trade receivable debts (SLCA) X Cr. Sales a/c X For a business which supplies goods/services on credit terms it is inevitable that irrecoverable debts (bad debt) will arise in relation to those sales.

Indroduction The amount owed by credit customer should only be classed as an asset (trade receivable) if it is probable that it is recoverable. (ie that the customer will pay the amount due). If it becomes apparent that a customer will not pay, the item no longer meets the definition of an asset. The accounting treatment will depend upon whether the debt is considered to be an irrecoverable debt (bad debt) or a doubtful debt.

Assessment focus point There are two main ways in which this topic could be tested: It could form part of a task on ‘accounting adjustments’, with calculations required. You may be asked to include irrecoverable and doubtful debts in the trial balance. VAT implications are not required

Irrecoverable debts (Bad Debts) These debts are owing to a business which it considers will never be paid –definitely irrecoverable. These debts need to written off to the statement of profit or loss. Remove from the sales ledger control account

TREATMENT OF IRRECOVERABLE DEBTS- DOUBLE ENTRY Irrecoverable debts are written off when they become uncollectable. In the Main Ledger Debit – irrecoverable debts account Credit – trade receivable’s account We do not debit the sales (revenue) a/c as sale itself was bona fide (authentic, genuine). At year-end: Transferred to SPL as an expense Debit – statement of profit or loss Credit – irrecoverable debts a/c

TREATMENT OF IRRECOVERABLE DEBTS- DOUBLE ENTRY Also, in the subsidiary sales ledger: Cr. Customer’s individual account – to remove the debt X (to match the entry in the SLCA) Example: Lewis reviews his receivables (which total £10,000) and notices an amount due from John of £500. He knows that this will never be recovered so he wants to write it off.

Sales ledger control a/c Irrecoverable debts expense a/c Solution: Double entry- D/E Sales ledger control a/c £ Bal b/d 10,000 Irrecoverable debts Balance c/d 500 9,500 Balance b/d Irrecoverable debts expense a/c £ S/L Control 500 SPL  

Solution: Double entry- D/E In the subsidiary sales ledger there will also be an entry in John’s account: John’s a/c £ Bal b/d 500 Irrecoverable debts written off The accounting treatment of irrecoverable debts means that the debt is completely removed from the accounting records and the statement of profit or loss is charged with an expense i.e it will reduce the profit by £500  

Journal entry to write off the debt Account Name Debit £ Credit £ Irrecoverable debts 500 SLCA Being: Write off an irrecoverable debt – Account of Jones written off as irrecoverable in the sales ledger – Credit Jones £500. SPL Being: Transfer to the SPL of irrecoverable debts for year

Recovery of a debt From time-to-time, a former trade receivable whose account has been written off will make a payment DEBIT – BANK/CASH CREDIT – IRRECOVERABLE DEBTS A/C (or a separate irrecoverable debts recovered account) - (SPL) (at the end of the year, debts recovered are transferred to the credit column of the statement of profit or loss as income. This will have the effect of increasing the profit for the year)

Case study: recovery of a debt T Hughes is a customer – the balance of his account of £25 was written off as a irrecoverable debt on 15 December 20-7. Today, on 15 April 20-8, T. Hughes wishes to pay off the amount of the debt – with a cheque for £25 See: Osborne Tutorial: Pg 117

You TrY: ACTIVITY 7.1 -OSBORNE TUTORIAL Page 127

Allowance for doubtful debt Some trade receivables accounts will give the business concern - they may never be paid. This is a debt which is possibly irrecoverable. An allowance for doubtful debt needs to be made against the debt - as a prudent precaution. NOTE: The business cannot show the full amount of trade receivables on the Statement of Financial position as an asset, to do this implies that the business will get the full amount (recoverable).

Allowance for doubtful debt Allowance for doubtful debts is the estimate by a business of the likely percentage of its trade receivables which may become irrecoverable during any one accounting period. Note the debt is not written off (in the SLCA) as it is not certain that they are irrecoverable. Allowances reduce the value of receivables in the statement of financial position (SOFP)

Treatment for allowance for doubtful debts (ADD) Allowance of D.D is different from irrecoverable debts, because there is only the possibility (not certainty) that these debt will not be paid.

Accrual principle of accounting Allowance of doubtful debts (ADD) is an application of the accrual basis of accounting. By reducing the trade receivable figure, a more accurate figure is shown in the statement of financial position (SOFP) of the amount that the business can expect to receive. Extract of SOFP Current Assets: Inventory X Trade receivables X Less Allowance for doubtful debt (X) X

Allowance for doubtful debt A new account is created, called allowance for doubtful debts account. (SOFP a/c) This account balance is offset against the trade receivables (sales ledger control account) balance in the statement of financial position (following the accrual basis of accounting) and the expense taken to the statement of profit or loss via the allowance for doubtful debts adjustment account. (SPL a/c)

Treatment for allowance for doubtful debts Allowance for doubtful debts account: this records the accumulated total of the allowance (SOFP a/c) Allowance for doubtful debts: adjustment account :this records the amount to create, increase or decrease the allowance each year (SPL a/c).

TYPES OF ALLOWANCE There are two types of allowances to consider: SPECIFIC ALLOWANCES: provided where there is doubt over the recoverability of a particular customer’s balance. GENERAL ALLOWANCES: a % applied to the total receivables (sales ledger control account balance) after: (i) Writing off irrecoverable debts (ii) Deducting the total balance owed by any customers for whom a specific allowance has been made. The general allowance is increased or decreased as necessary at year end.

specific allowance Is an allowance applied to one or more specific debts where the risk of default is thought to be higher

General allowance Is an allowance applied to the total trade receivables after writing off irrecoverable debts and taking account of any specific allowance

Rules for calculating the general allowance Take the following steps in this order: Take the receivables balance per the sales ledger control account 2. Deduct the irrecoverable debts (bad debts) and 3. Then deduct any amounts specifically provided for 4. Then finally calculate the general allowance on the balance (ie after taking account of bad and specific debt). Each business will have a specific policy regarding general allowances.

Rules for calculating the general allowance Receivables Balance (Debtors) £ Less Irrecoverable Debts to be written off (£) £ Less Specific allowance (£) General allowance % applied to …………… ? Total allowance = specific + general allowance Remember: only the movement in the general allowance needs to be accounted for in the statement of profit or loss

Assessment focus point In the assessment you will need to calculate the account for doubtful debts in accordance with the policy of the organisation stated in the task. Example: ‘ The allowance for doubtful debts needs to be adjusted to 1% of outstanding trade receivables.’

Example: OSBORNE Page 113 A business with trade receivables of £10,000. Trade receivables accounts totalling £200 are to be written off as a bad debt (irrecoverable debt) An allowance for doubtful debts is to be made amounting to 2% of the remaining trade receivables after the £200 has been off.

Example: OSBORNE Page 113 Gross trade receivables £10,000 Less: irrecoverable debt £ 200 £ 9,800 Less: allowance for doubtful debts @ 2% £ 196 Net trade receivables £ 9,604 Note: the level of percentage is likely to reflect the level of risk of the doubtful debt

Extract of SOFP – Current Assets – DOUBTFUL DEBT Inventory (Stock) x Trade receivables (SLC) 9,800 Less allowance for Doubtful debt 196 9,604 Prepayment of expenses x Accrual of income x Bank/Cash x x

You Try Activity Osborne Tutorial 7.3 Pg 127

Initial creation of an allowance for doubtful debt Making an allowance for doubtful debts comes after writing of the irrecoverable debts (if any): Study: STEPS 1 – 4 (Osborne Tutorial page 118) Pg 118

Adjustments to allowance for doubtful debt Once an initial allowance for doubt debt has been created, only the adjustments (an increase or a decrease in the allowance) need to be made thereafter as a result of: A policy change- e.g change in the fixed percentage. An arithmetical adjustment- change in the trade receivables

Increasing the allowance This is recorded into the double-entry bookkeeping system as follows: DEBIT - allowance for doubtful debts: adjustment account (SPL) (with the amount of increase) CREDIT – allowance for doubtful debts account (SOFP) (with the amount of increase). Transfer out of adjustment account to SPL.. DEBIT – statement of profit or loss (Expense) CREDIT – allowance for doubtful debts: adjustment account

You Try Osborne Tutorial Activity 7.2 Page 127

decreasing the allowance This is recorded into the double-entry bookkeeping system as follows: DEBIT - allowance for doubtful debts account (SOFP) (with the amount of increase) CREDIT – allowance for doubtful debts: adjustment account (SPL) (with the amount of increase) Transfer out of adjustment account to SPL.. DEBIT – allowance for doubtful debts: adjustment account (SPL). CREDIT – statement of profit or loss (Income)

Irrecoverable debts and doubtful debts ACCOUNTS PREPARATION

Case study: how it works Osborne Tutorial Pages 120 -122 Study the example Pg 120

You Try Activity 7.4 Osborne Tutorial Pg 128 Activity 7.5

The extended trial balance Case study Osborne Tutorial Page 124 Study the example Tara Smith Irrecoverable debts and allowance for doubtful debts Pg 124

Class Activity: ND Trading has a balance on its sales ledger control account at 31 December 20X5 of £60,000. Included within this balance is £3,000 of irrecoverable debts to write off and a specific allowance to be made of £600. At 31 December 20X4, the allowance for doubtful debts will be 3% of the outstanding trade receivables. Complete the trial balance extract by entering the figures in the correct places.

Trial balance (Extract) Ledger accounts Ledger balances Dr £ Cr £ Sales ledger control Irrecoverable debts Allowance for doubtful debts Allowance for doubtful debt -adjustments

Trial balance (Extract) Ledger accounts Ledger balances Dr £ Cr £ Sales ledger control 57,000 Irrecoverable debts 3,000 Allowance for doubtful debts 2,292 Allowance for doubtful debt -adjustments 292 Workings: Opening balance per sales ledger control 60,000 Less Irrecoverable debts ( 3,000) Adjusted balance per sales ledger control account 57,000 Less specific allowance ( 600) 56,400 General allowance (£56,400 x 3%) 1,692 Total allowance = £600 + £1,692 = £2,292 ADD adjustment: Opening allowance £2,000 Adjustment to TB SPL £ 292 Closing allowance – to TB SOFP £2,292

Osborne Tutorial – Activities 7.6 to 7.7 Your Try: Activities Osborne Tutorial – Activities 7.6 to 7.7

Irrecoverable debts and doubtful debts - Summary ACCOUNTS PREPARATION

Example Ross Engineering has an existing allowance for doubtful debts of £300 based on 5 per cent of receivables. After writing off irrecoverable debts, the amounts of receivables at the end of the next two financial years are found to be: 31 December 20-5 £8,000 31 December 20-6 £7,000 The business continues to keep the allowance for doubtful debts equal to 5 per cent of receivables. You are to show how the allowance for doubtful debts account and allowance for doubtful debts: adjustment account will be adjusted at the end of the financial years ended 31 December 20-5 and 31 December 20-6, and how it will be recorded in the appropriate financial statements.

Allowance for doubtful debts account (SOFP a/c) Solution: Allowance for doubtful debts account (SOFP a/c) 20-5 £ 1-Jan Balance b/d 300 31-Dec Balance c/d 400 Allowance for doubtful debts: adjustment (increase in allowance) 100 20-6 (decrease in allowace) 50 350 20-7

Allowance for doubtful debts: adjustment account (SPL a/c) 20-5 £ 31-Dec Allowance for doubtful debts: 100 SPL 20-6 50 Allowance for doubtful debts 400

Statement of profit or loss for the year ended 31 December 2005 Extract from financial statements produced for year ended 31 December 20-5 Statement of profit or loss for the year ended 31 December 2005 Expenses: Dr Cr Allowance for Doubtful debt-adjustment (increase) 100 Statement of Financial Position as at 31 December 2005 Current Assets: Inventory x Receivables-(Sales Ledger Control ) 8,000 Less: Allowance for Doubtful Debts (400) 7,600

Statement of profit or loss for the year ended 31 December 2006 Extract from financial statements produced for year ended 31 December: 20-6 Statement of profit or loss for the year ended 31 December 2006 Other Income Dr Cr Allowance for Doubtful debt-adjustment (reduction) 50 Statement of Financial Position as at 31 December 2006 Current Assets: Stock (Inventory) x Sales Ledger Control (Receivables) 7,000 Less: Allowance for Doubtful Debts (350) 6,650

Homework Lesson 8 – Chapter 7 Read chapter 7 and answer all questions in Tutorial book and work book (Osborne) Do the TZ activities – Will be collected next week for marking. (Osborne) Read ahead Chapter 8: The rules of accounting for next week. (Osborne) Additional activities (Optional): BPP Knowledge Topic KT7 BPP Question Bank activities

The end Any question?