BOOKKEEPING FORM THREE TOPIC 6: BAD DEBTS

BAD DEBTS

Bad Depts

The Bad Depts Account

Show the bad debts account

What are bad debts?

The term bad debts usually refers to accounts receivable (or trade accounts receivable) that will not be collected. However, bad debts can also refer to notes receivable that will not be collected.

The bad debts associated with accounts receivable is reported on the income statement as Bad Debts Expense or Uncollectible Accounts Expense.

When the allowance method is used, the journal entry to Bad Debts Expense will include a credit to Allowance for Doubtful Accounts, a contra account and valuation account to the asset Accounts Receivable. The allowance method anticipates the losses and therefore requires the use of estimates.

Under the direct write-off method, the Allowance for Doubtful Accounts is not used. Rather, Bad Debts Expense will be debited when an account receivable is actually written off. The credit in this entry will be to the asset Accounts Receivable.

Accounting entry required to write off a bad debt is as follows:

Debit	Bad Debt Expense
Credit	Receivable

The credit entry reduces the receivable balance to nil as no amount is expected to be recovered from the receivable. The debit entry has the effect of cancelling the impact on profit of the sales that were previously recognized in the income statement.

Example 1

Example

ABC LTD sells goods to DEF LTD for $500 on credit. ABC LTD subsequently finds out that DEF LTD is being liquidated and therefore the prospects of recovering its dues are very low.

ABC LTD should write off the receivable from DEF LTD in view of the circumstances. The double entry will be recorded as follows:

		$	$
Debit	Bad Debt Expense	500
Credit	DEF LTD (Receivable)		500

Bad Debt Recovered

Occasionally, a bad debt previously written off may subsequently settle its debt in full or in part. In such case, it will be necessary to cancel the effect of bad debt expense previously recognized up to the amount settlement.

Example 2

Example

ABC LTD sells goods to DEF LTD for $500 on credit. ABC LTD subsequently finds out that DEF LTD is being liquidated and therefore the prospects of recovering its dues are very low. ABC LTD therefore writes off the receivable from its books. However, the administrator appointed to oversee the liquidation of DEF LTD instructs the company to pay $300 to ABC LTD in full settlement of its dues.

As $300 of the bad debt has been recovered, it is necessary to cancel the effect of previously recognized bad debt expense up to this amount. The accounting entry will therefore be as follows:

		$	$
Debit	Cash	300
Credit	Bad Debt Recovered (Income)		300

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Provision for Bad Debts Account

The provision for bad debts account

The provision for doubtful debts is the estimated amount ofbad debtthat will arise from accounts receivable that have been issued but not yet collected. Itis identical to the allowance for doubtful accounts. The provision is used under accrual basis accounting, so that an expense is recognized for probable bad debts as soon as invoices are issued to customers, rather than waiting several months to find out exactly which invoices turned out to be uncollectible. Thus, the net impact of the provision for doubtful debts is to accelerate the recognition of bad debts into earlier reporting periods.

A business typically estimates the amount of bad debt based on historical experience, and charges this amount to expense with a debit to the bad debt expense account (which appears in the income statement) and a credit to the provision for doubtful debts account (which appears in the balance sheet). The organization should make this entry in the same period when it bills a customer, so that revenues are matched with all applicable expenses (as per the matching principle).

The provision for doubtful debts is an accounts receivable contra account, so it should always have a credit balance, and is listed in the balance sheet directly below the accounts receivable line item. The two line items can be combined for reporting purposes to arrive at a net receivables figure.

Later, when you identify a specific customer invoice that is not going to be paid, eliminate it against the provision for doubtful debts. This can be done with a journal entry that debits the provision for doubtful debts and credits the accounts receivable account; this merely nets out two accounts within the balance sheet, and has no impact on the income statement. If you are using accounting software, create a credit memo in the amount of the unpaid invoice, which creates the same journal entry for you.

It is highly unlikely that the provision for doubtful debts will always exactly match the amount of invoices that are actually unpaid, since it is only an estimate. Thus, you will need to adjust the balance in this account over time to bring it into closer alignment with the ongoing best estimate of bad debts. This can involve an additional charge to the bad debt expense account (if the provision appears to initially be too low) or a reduction in the expense (if the provision appears to be too high).

Example 3

Example

ABC LTD has trade receivable of worth $50,000 as at 31 December 2010. XYZ LTD, a receivable owing $10,000 to ABC LTD at the year end, has been recently been wound up. Consequently, ABC LTD does not expect to recover the amount due from XYZ LTD. Based on past experience, ABC LTD estimates that 5% of its receivables will default. Allowance for doubtful debts on 31 December 2009 was $1500.

ABC LTD must write off the $10,000 receivable from XYZ LTD as bad debt. Accounting entry to record the bad debt will be as follows:

		$	$
Debit	Bad Debt Expense	10,000
Credit	XYZ LTD (Receivable)		10,000

A general allowance of $2,000 [( 50,000-10,000) x 5%] must be made. As a general allowance of $1500 has already been created, only $500 additional allowance must be charged to the income statement:

		$	$
Debit	Allowance for Doubtful Debts (Expense)	500
Credit	Allowance for Doubtful Debts (Balance Sheet)		500

Note that $10,000 in respect of receivable from XYZ LTD has been excluded from the calculation of the general allowance as it has already been written off in full:

Bad Debt Expense
Debit	$	Credit	$
XYZ LTD (Receivable)	10,000	Income Statement	10,000
	10,000		10,000

XYZ LTD Receivable
Debit	$	Credit	$
Sales	10,000	Bad Debt Expense	10,000
	10,000		10,000

Allowance for Doubtful Debts
Debit	$	Credit	$
Balance c/d	2,000	Balance b/d	1,500
		Income Statement	500
	2,000		2,000

Preparation of a Computation of the Amount to be Shown as Trade Debtors in the Company Balance Sheet

Prepare a computation of the amount to be shown as Trade debtors in the company balance sheet

The bad debts after trial balance, provision for doubtful debts and provision for discount on debtors will appear in the balance sheet as

Debtors	xxxx
Minus: Bad debts	xxxx
Minus: Provision for doubtful debts	xxxx
Minus: Provision for discount on debtors	xxxx

Preparation of a Provision for Discounts on Debtors

Prepare a provision for discounts on debtors

Provision for discount on debtors

In business world a lot of sales transactions happen on credit, i.e. after a specified period of time. In this scenario, there are two main types of discounts allowed to customers. One is trade discount and the other is acash discount.

Now, after anticipating the amount of cash discount allowable to debtors, a separate “provision for discount on debtors account” is opened and it is very similar to the “provision for doubtful debts account”. The only difference between the two is that provision for discount is calculated on the debtors’ balance after deducting the provision for doubtful debts.

Journal Entry for Creating a Provision on Discount on Debtors

Profit & Loss A/C	Debit
To Provision for Discount on Debtors A/C	Credit

• If a provision for discount on debtors exists at the time of providing discount, then write off the discount from that provision.
• A new provision should then be calculated to the extent of bringing the existing provision to thenew figure. Ajournal entry would include debiting P&L account and crediting provision for discount on debtors.
• If new provision required is lower than the provision already existent, then we need to transfer the difference to P&L account. In this case, the journal entry would be reverse of what is mentioned in the previous point.

• READ TOPIC 7: Financial Statements

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