CHAPTER 11
BAD DEBTS AND ALLOWANCES FOR DOUBTFUL DEBTS
11.0 LEARNING OBJECTIVES
This section will cover some adjustments that must be made to the accounts in the form of: bad debts and allowances for doubtful debts
11.1BAD DEBTS AND PROVISION FOR DOUBTFUL DEBTS (Uncollectable accounts Receivable): Bad debts arise from credit sales. Customers who buy goods on credit may fail to pay perhaps due to dishonesty, bankruptcy or death. For one reason or another business may decide that a debt is uncollectable. Bad debts are a business risk. They are therefore accounted for as normal business expenses. They must be charged to the Income Statement as an expense when calculating profit.
11.2 WRITING OFF UNCOLLECTABLE ACCOUNTS RECEIVABLES:
When a sale is made, the invoiced amount is shown in the trading account and the gross profit earned is shown in the account. Subsequent failure to collect the debt is a separate matter which is reported in the Income Statement as bad debts written off.
ILLUSTRATION
(I) ABC Traders sold goods to John worth K 3000.00 on 29th June 20xx
Account Entry 1 Debit John (Debtor) K 3,000
Credit Sales K 3,000
These two entries will subsequently go into the trial balance and be taken to the trading account.
(ii) At the end of the accounting period it ascertained that John will pay his debt of
K 3000
Accounting Entry: Debit Bad Debts Account K 3,000
Credit John K 3,000
When posted the account of John as a debtor will balance off.
The value of John as a debtor becomes zero. The bad debts account reduces the profit that would have been reported during that period.
11.3 BAD DEBTS WRITTEN OFF AND SUBSQUENTLY PAID
Sometimes a debtor who was written off may pay. In such case the amount received should be recorded as additional income in the Income Statement of the period in which
the payment is received. The entries to affect this would be: –
- Cash Received K 3000
John K 3000
Recording the receipt of cash asset 93
- John K 3000
Bad debts Recovered K 3000 Introducing the Bad Debt recovered Account
- Bad Debts recovered Account K 3000
Income Statement K 3000
Transferring the amount previously written off to the current Income Statement.
11.4 ALLOWANCES FOR DOUBTFUL DEBTS
The previous section has assumed that the bad debtor John was a known customer. In most business situations the identities of uncollectable amounts is not known until after some period. When a business expects uncollectable debts but does not yet know which specific debts will be bad, it can make a provision for doubtful debts. A provision for doubtful debts provide for future bad debts as required by the prudence concept.
Determining the size of the Provision
A provision for bad and doubtful debts may be estimated through: – x Past experience: Experience will show how many debtors default payment after a certain period
x Aging: A process of aging will show how many debtors remain past the credit period.
x Percentage of outstanding debtors: Like experience, businesses have established percentages of defaulting debtors in their respective areas of trade.
(a) Making the Provision
When a provision is made for the first time the initial amount of the provision is charged as an expense in the Income Statement.
Increasing the Provision
When a provision already exists but is to be increased, the amount of the increase in the provision is charged in the Income Statement as an expense.
ILLUSTRATION
ABC Traders have decided to increase the provision to K 520,000
Debit Income Statement K 20,000
Credit Provision for Doubtful Debts K20,000
To increase the provision.
In the Income Statement only K 20,000 would be charged as an expense for the period. In the Balance Sheet K 520,000 (the whole amount) should be deducted from total amounts of receivables.
(c) Reducing the Provision
When a provision already exists but there is need to reduce it, the amount of the reduction should be credited to the Income Statement and debited to the Provision Account.
ILLUSTRATION
ABC Traders have decided that that the provision for doubtful debts should be reduced to K 510,000 this year
Entry: Debit Provision for Doubtful debt K 10,000
Credit Income Statement K10,000
To reduce the Provision. In the Income Statement only K 10,000 will be credited. In the Balance Sheet the whole amount of the revised provision of K 510,000 should be deducted from the total debtors.
SUMMARY
A business cannot avoid losses arising from bad debts: – x Bad debts should be written off as soon as they are known.
x If a debtor was written off, but subsequently pays his or her debt, the amount received must be added to the Income Statement of the period in which cash was received. x When the specific debt is not yet known a provision for the general debts must be made through a charge to the Income Statement. x Changes in the provision will be affected through debiting or crediting the Income Statement with the difference i.e. debiting to increase or crediting to decrease the provision. x The adjusted provision should be deducted from total accounts receivable in the balance Sheet to give a realistic estimate of the net realizable value of the receivables.
SUMMARY OF THE CHAPTER
This chapter illustrated the nature and purpose of the allowance for doubtful debts including how the allowance may be estimated, the accounting entries necessary to recognize the allowance, how the allowance may be increased or decreased and the impact of cash discounts on accounts receivable.
END OF CHAPTER QUESTIONS
Q1 A business has always made an allowance for doubtful debts at a rate of 5% of trade receivables. On 01st January 2013 the allowance for this, brought forward from the previous year, was K260,000.
During the yearto 31st December 2013 the bad debts written off amounted to K540,000. On 31st December 2013 the remaining trade receivables totaled K6,200,000 and the usual allowance for doubtful debts should be made.
You are to show:
- The Bad Debts Account for the year ended 31 December 2013.
- The Allowance for Doubtful Debts Account for the year.
- Extract from Income Statement for the year.
- The relevant extract from the Statement of Financial Position as at 31st December 2013.
Q2 Discuss why an accountant only need to create an expense for the difference between provisions (allowances) for two years.