Bad debts aren't so bad!

IRRECOVERABLE AND DOUBTFUL DEBTS

Debtors should only be included as assets in a balance sheet if they are expected to settle the amounts due from them. The prudence concept requires an organisation to recognise future losses as soon as it becomes aware of their existence. This means that as soon as an organisation is aware that a debt may not be settled, then the asset value should be reduced by an adjustment being put through the accounts.

Irrecoverable debts (Bad debts)

This is a debt that will NOT be recovered. It should be completely removed from the ledger accounts and therefore from the balance sheet.

Double entry to account for an irrecoverable debt

Dr Irrecoverable debt                    X          (Income statement)

Cr SLCA                                             X          (Statement of financial position)

Example

Doubtful debts

This is a debt about which there is some question as to whether or not the amount will be settled. We must recognise this doubt in the accounts but we should not write off the debt completely, because the cash may be received. In any event we need to keeping pressing for it to be settled. Therefore we still need to show the debt as outstanding.

Example 1

Doris has debtors at her year-end of £25,000.

There is concern about whether £5,000 of this will be settled.

Dr Allowance for doubtful debt adjustment £5,000

Cr Allowance for doubtful debt £5,000

The allowance for doubtful debts is offset against the receivables’ balance in the statement of financial position.

Statement of financial position extract

This treatment clearly shows that there is doubt as to whether the debt will be received but does not write it off and we can continue chasing it. Receivables will be reduced by the £5,000 in the statement of financial position.

Changes in allowance

As you are aware, any item that appears in the statement of financial position is carried forward into the next accounting period. This means that there may be a balance on the allowance for doubtful debts account brought forward.

It is unlikely that the allowance will stay the same from one year to the next, so you may need to change the amount carried in the statement of financial position.

The key thing to remember is that you only need to take account of either the increase or the decrease in the allowance, in the profit and loss account.

Increase

Dr Allowance for doubtful debt: adjustments               X

Cr Allowance for doubtful debts                                                  X

In each case you would only enter the increase in the allowance e.g. last year £5,000 this year £7,000 therefore only an extra £2,000 would be charged to the irrecoverable debt account.

Decrease

Dr Allowance for doubtful debts                                      X         

Cr Allowance for doubtful debt: adjustments                           X

In each case you would only enter the decrease in the allowance e.g. last year £5,000 this year £3,000 therefore only remove £2,000.

It is common for students to change the allowance by the new allowance figure instead of to the new allowance figure - don't fall into that trap!