Irrecoverable Debts and Provision for Doubtful Debts | O Level Accounting 7707 & IGCSE Accounting 0452 | Detailed Free Notes To Score An A Star (A*)

Irrecoverable Debts

• At times, when we have an accounts or notes receivable, the customers are not able to pay
  • It could be in bad faith
  • The customer may go broke as well.
  • Or we may anticipate that the customer may never pay his debt
• Important thing to note
  • It is only on debtors who have purchased INVENTORY on credit.
  • Not those who have purchased something else on credit.
• Irrecoverable Debts
  • Also called bad debts
  • They need to be written off, or removed from the accounts as a loss (operative expense) to give us a true picture of the actual accounts receivable present.
  • Remember, Bad Debt entry is ONLY passed in income statement.
  • There are two entry methods
    • Direct write-off (write-off means to remove from accounts) method
      • • Bad debt expense is debited
        • Accounts receivable is credited
      • In such cases, recovery entries are also direct.
        • Recovery means when a debt previously considered bad is recovered i.e. paid by the customer.
      • In direct write-off method
        • We will use the following 2 entries:
          • First entry
            • Accounts Receivable will be debited
            • Bad Debts expense will be credited
          • Second Entry
            • Cash or bank debited
            • Accounts Receivable Account will be credited
    • However, we usually use the Allowance or provision for bad debts method instead.
      • This is based on the prudence principle as we anticipate a loss and matching principle to match it to the period when it was anticipated much like depreciation. Therefore, here, bad debts is a non-cash expense initially.
      • When a bad debt occurs, we increase an account called allowance for doubtful debts and reduce our accounts receivable
        • Debit Provision/ Allowance for doubtful debts
        • Credit Accounts Receivable
        • Then we make a second entry when the bad debt actually happens
          • Bad debt expense is debited
          • Allowance/ provision for doubtful debt accounts credited
      • In some cases, we first pass the second entry based on anticipation to match the accounts when the bad debt was anticipated. Then when the actual bad debt occurs, we pass the first entry to write off directly from accounts receivable.
      • When the Recovery Occurs
        • We debit the accounts receivable account
        • We credit the allowance/ provision for doubtful debts account.
      • Then we pass a second entry for recovery
        • Cash or bank debited
        • Accounts Receivable will be credited
• Remember, the examiner will trick you in 3 ways.
  • First, new provision for doubtful debts can be calculated at percentage of sales
    • We find the percentage of sales, and it is the new provision
  • New provision can also be calculated as the percentage of accounts receivable
    • We find the percentage of accounts receivable and that is the new provision
  • Now there is a difference
    • If we says “new provision is increase by 5 percent of accounts receivable, we just add the new 5 percent)
    • If he says “Make the total provision at 5 percent of accounts receivable”
      • We will first calculate the 5 percent. This will the total provision
      • Then, we will minus the old provision already existent in the accounts to determine the increase or decrease in provision.
• Treatment in accounting statements
  • In income statement
    • In operative expenses, we do B + N – O
      • Bad debts+ New provision – Old Provision (i.e. bad debts + change in provision)
      • If the answer is a positive number (greater than zero), add the final value in OPERATIVE Expenses. It means overall provision has increased
      • If the answer is a negative number, less than zero, add it to the gross profit. It means overall provision has decreased.
  • In statement of financial position
    • In the current assets section
      • Simply reduce the NEW PROVISION from Accounts Receivable to get net account receivables value
• Remember
  • A bad debt expense account will have no CD, as the balance at the end if carried to the income statement. Income statement is debited to show operative expense, and the bad debt expense is credited at the end of the period to equal the totals on both sides.
  • The change in provision i.e. new provision – old provision for allowance for doubtful debts will be credited in the allowance for doubtful debts account and debited in the income statement to show a operative expense.