Chapter 7 - Trial Balance and Financial Statements - Adjustments to Monetary Values in Financial Statements: Bad Debt, Trade Receivables Impairment and Allowance for Doubtful Debts Flashcards
Bad Debt
It’s treated as an expense in the Income Statement.
When preparing Financial Statements it’s necessary to make allowances for the fact that not all trade receivables are going to be collected.
Categories of unpaid debt
Bad Debt
A customer debt that is not going to be paid due to bankruptcy, liquidation, cassation of trade, lack of assets, consumer ‘gone away’, and all efforts to collect the debt have been unsuccessful.
If the debt is small, the cost of pursuing it are not justified, specially if there is obviously no chance of recovering it.
Prudence concept implies this asset is likely impaired,
Categories of unpaid debt
Doubtful Debt
when there is a degree of uncertainty if a particular customer will be paying their debt. That is, there are going to be some trade receivables that aren’t going to be paid, but it is uncertain which ones.
Prudence concept states that some of these assets may be impaired.
Bad Debt
when a bad debt is clearly such and not going to be paid, the decision must be made for it to be written off, and deducted as bad debt from the profit in the Income Statement.
Amount should be written off in the debtor’s account, and the account closed.
Bad Debt write off in ledger
- Credit to the customer’s account in the Sales Ledger
- Debit in the Bad Debts account in the Nominal Ledger
VAT amount is included in the write off amount.
Bad Debt in the Income Statement - example
Income Statement
Gross Profit 9,000 Less Expenses Heat and Light 550 Insurance 800 Office Expenses 900 Bad Debt 700
This will reduce the trade receivables from the Trial Balance, and then the Net Profit used to calculate the Statement of Financial Position
Doubtful Debt and Prudence Concept
Common practices include a ‘provision’ calculation to account for possible future loss in the trade receivables, it is usually an arbitrary % of total debtors.
The HMRC questions this though, as expenses will decrease the company’s profit, and companies are taxed on their profit.
Nowadays it is called ‘bad debt provision’, and the prudence concept requires that such an allowance is made. they should be ideally backed up with past debt experiences, the business’ environment, with justification for the decisions made.
Justifying the allowance for doubtful debt
Allowance based on receivables that are not overdue , where paying has been made, or where no loss has occurred is beyond the current rules
Specific provision (no longer compliant with current rules)
Review of individual debts, age and amount of debt, and payment patterns of customers.
This would be completely impossible in large companies, even if there are computerised systems.
Even though analysing specific customers may seem a near match, it is still subjective.
General provision (no longer compliant with current rules)
Percentage calculation of the trade receivables to represent the amount that may not be paid. This amount may be based on actual bad debt that has been written off in the past.
For instance, if the amount written off was 2% of the trade receivables, the company will use the same percentage.
Aged Receivables Schedule
Used for picking out likely problem customers, as it shows how long debts have been outstanding.
The longer the debt is overdue, the more difficult it will be to collect it.
International Financial Reporting Standard 9 (IFRS 9)
This reporting standard deals with the perceived impairment of financial assets for reporting periods starting from January 2018.
It controls how deterioration is calculated.
The IFRS 9 proposes a ‘simplified approach’ to assess the likely impairment of trade receivables, so it’s a more trusted value as considered by the HMRC. If fully justified when challenged, it is acceptable. As long as are detailed calculations and justifications as to why they were used and done that way.
International Financial Reporting Standard 9 (IFRS 9)
‘Provision Matrix’
The ‘provision matrix’ is similar to a scorecard screening procedure, the more it is used, the more accurate it becomes in forecasting loss, due to the number of experiences built into it.
It uses actual data and current events to calculate allowance for doubtful debt.
The matrix considers: age of debts not being paid, current business environment, any other intervening factor
Environmental Calculation
External factors may impact future losses, but it also needs to be justified.
Example: 1% redundancies in an area link to 1% loss.
Trusted bodies, such as the Chamber of Commerce, may provide forecasting
Allowance for doubtful debt
It is calculated after the Trial Balance has been drawn up at the end of the Financial Year.
Whilst Bad debt will be entered in one customer account, provision for bad debt doesn’t affect a particular customer(s) account(s) at all.
