Chapter 10: Bad and doubtful debts Flashcards
10.1 Introduction
Bad and doubtful debts is historically referring to when a business sells goods on credit but does not get paid, or is unlikely to be paid, FRS 102 Section 11 refers to it as impairment losses and they can also be called provisions for doubtful debts. In practice you normally use provisions for doubtful debts when referring to the recording of the transaction and impairment losses when referring to the presentation in the financial statements. Also, under FRS 102 debtors can be referred to as receivables.
The original sale – when a business makes a sale it can be either:
• A cash sale, where the business gets the cash or cheque immediately. The accounting entry is:
£ £ Dr Bank X Cr Sales with the sales value X
• A credit sale, where the business raises an invoice at the time the goods and services are supplied to the customer, but it receives the payment from the customer at a later date. The accounting entry is:
£ £
Dr Debtors X
Cr Sales with the sales value X
The debit balance on debtors represents an asset. At this point there has been no impact on cash as the customer has not paid for the goods or service yet. When payment is received from the customer, this is when the cash balance will increase. When the business allows a customer a period of time (credit period), in which to pay, the business is taking a risk that the money will never be received. This is a normal business risk.
A bad debt or a doubtful debt – there are two situations you need to consider when a sale on credit has taken place, but the debt has not been settled.
- A bad debt arises when a debtor is unable or unwilling to pay the invoice
- A doubtful debt arises when a debt becomes uncertain that money may not be received. For example, if there are many debtors, the law of averages suggested a proportion may never be received. Press information may hint at the possible bankruptcy or insolvency of a customer. If the debt has remained unpaid for a considerable period of time
10.2 The Bad Debt
If it is certain the debtor will not pay, the debt must be removed from the business’s books. The loss of this debtor is an expense of the business and this bad debt expense is charged to the P+L. Sales in the trading account remain the same, as it was the collection of the debt which was the problem. The accounting entries for bad debt is:
£ £ Dr Bad debt expense (P+L account) X Cr Debtors (balance sheet) X
10.3 The Doubtful Debt (1)
If it is uncertain whether the debt will be recovered, the debit says as an asset but a provision (or impairment) is created against it. This is the provision for doubtful debts. In the balance sheet, trade debtors are presented net of the associated provision for doubtful debts. This is similar to fixed assets which are shown net of the associated provision for depreciation. The accounting entry for a provision for doubtful debts is initially:
£ £ Dr Bad debts expense X Cr Provision for doubtful debts X with the required provision for specific debts that are considered doubtful
The accounting entries required when the provision for doubtful debts is altered –
After a provision is set up, it is reviewed each year. If the provision for doubtful debts is inadequate and needs to be increased, then we need to calculate the amount of new provision and account for the increase. We reflect that increase as follows:
£ £ Dr Bad debts expense account X Cr Provision for doubtful debts account X (only account for the increase in the movement of the provision)
If the provision for doubtful debtors is too great and needs to be released or decreased, then we calculate the amount of the new provision and account for the decrease. We reflect the decrease as follows:
£ £ Dr Provision for doubtful debts X account (only account for the decrease in the movement of the provision) Cr Bad debts expense account X
10.3 The Doubtful Debt (2)
The recovery of a debt which has previously been written off –
A debtor had been anticipated to be bad and has been removed from the accounts. However, if cash is unexpectedly received from this debtor, we need to account for this. Since the debtor is no longer in the business’s books and account has been taken of the loss suffered through the profit and loss account, this receipt of cash is considered as extra profit. To reflect the receipt of cash from the debtor, it is necessary to:
£ £
Dr Bank Account X
Cr Bad debts expense account X
The recovery of a debt which has previously been provided against –
The original debtor still remains recorded in the business’ books at its full value even through there is a provision set against it. To reflect that the debtor has been paid we record the cash received as follows:
£ £
Dr Bank Account X
Cr Debtors account X
We calculate the closing provision required by reviewing the debtors account. Since the debtors account has been reduced (with the cash received), we automatically take account that the provision will not be required at the year end when we recalculate the new closing provision.
10.4 Tax considerations
Bad and doubtful debts are important in a tax computation. Provisions are allowed to reduce profits since they relate to a specific debtor. Likewise, bad debts written off are allowed to reduce profits for the same reason.
10.5 Summary of bad and doubtful debts
Step One – set up ledger accounts for provision for doubtful debts and a bad debts expense and enter the opening balance into the provision for doubtful debts ledger.
Step Two – write off any bad debts, Dr Bad debts expense and Cr debtors, for any cash received from debtors. If a normal debtor or a debtor against which a provision has been made, then Dr Bank and Cr Debtors. If the cash has been received from a debt previously written off then, Dr Bank and Cr Bad debts expense.
Step Three – enter the movement in the provision for doubtful debts into the provision for doubtful debts ledger. For an increase in the provision, Dr Bad debts expense and Cr provision for doubtful debts. If a decrease in the provision occurs then, Dr provision for bad debts and Cr bad debts expense.
Step Four – balance off the debtor’s ledger, provision for doubtful debts ledger and the bad debts expense ledger.
