ACCA F3/FFA – Understanding Bad Debts & Allowance For Receivables

What is Bad Debts ? & what happens when a customer doesn’t pay the debts it owes to a business?

In modern times, many goods and services are sold to customers on a credit basis. This means that the goods or services are provided to the customer now and then paid later. A business that operates in this way that is by selling on credit runs the risk that some of the debtors will either not pay at all or only pay partially. If a business decides that there is a high possibility that a particular debtor will not pay their debts, then the debt becomes a bad debt. In business bad debts frequently result when a debtor goes into bankruptcy or the expenses of trying to recover the debt exceed the amount owed. 

Here are some of the main reasons why a bad debt may arise:

• A customer may go bankrupt. 
• The business may be a victim of fraud. 
• There could be a dispute on whether the goods were delivered.
• A dispute about standards of service.

Bad debts end up as such because the debtor can’t or refuses to pay because of bankruptcy, financial difficulty, or negligence. Before deciding that a bad debt is uncollectible, these companies may pursue all available options for collection, including collection activities and legal action. 

Examples :

Let’s illustrate bad debts with an example. Consider William as an online reseller. He recently sold some books to a customer on credit and it was agreed that the customer would pay $500 to William within 30 days. It’s now 40 days after the credit sale of the books. William has been in contact with the customer several times urging for the payment. As the customer has exceeded the 30 days agreed credit terms then William should consider the $500 as a bad debt.

If a business identifies that there is bad debt, then this will be recorded in the accounts as an expense in the Income Statements .

Irrecoverable Debts Written Off

Whenever a company estimates that a certain amount of its receivables are uncollectible it is required to record bad debt expense. The estimated uncollectible amount is tracked in a contra-asset account called allowance for doubtful accounts.

 When an estimated uncollectible becomes a known uncollectible, it is written off from both the receivables and allowance account. If a written-off account is eventually paid within an accounting period it must first be recorded by reversing the write-off and the entry will be:

DEBIT Receivable

CREDIT Bad debt expense account

In the next years if an amount is recovered which has been previously written off, then the entry will be:

DEBIT Cash

CREDIT  Bad debts recovered (other income)

Allowance For Receivables:

Most companies will estimate the amount of income they expect to lose due to bad debt based on the credit record of their customers. That figure is their bad debt allowance and is listed in the doubtful accounts section of a balance sheet. An allowance for receivables is a general estimate of the percentage of debts which are not expected to be paid. Investors should consider a company’s bad debt allowance when they review finances. Debtors with a history of bad credit will see their credit ratings suffer, making future loans and credit difficult to obtain.

We will open up an allowance account by the following entries:

DEBIT Bad debt expense

CREDIT Allowance for receivables

Example: 

Flyer corp. has $10,000 due from customers. It expects $1,000 of the balance may be uncollectible. However, at the end of the accounting period, only $200 is known to be collected. 

Now once you expect an uncollectible you do have to establish your contra asset (allowance account) for the portion of the uncollectible amount and we do that with the following general entry:

DEBIT Bad debt expense $1,000

CREDIT Allowance for doubtful debts $1,000

But at the end of the accounting period, $200 is known to be collectible.

Which we will record as

DEBIT Allowance for doubtful debts $200

CREDIT Accounts Receivables $200

This article sets out the accounting treatment for the impairment of trade receivables/debtors. The provision for bad debts is now, in effect, governed by IAS 39, Financial Instruments: Recognition and Measurement for International stream students or FRS 26, Financial Instruments: Measurement for UK stream students. Adapted papers generally follow the content of IAS 39.read more 

How To Record Bad Debts:

Businesses must first project their prospective losses before recording bad loans in the accounting books. Such an estimate is called a bad debt allowance, a bad debt reserve, or a bad debt provision. On the balance sheet, this provision for doubtful payments is shown as a contra-asset account. The bad debt write-off technique is an alternative that many small firms in the UK that adhere to IFRS standards may employ. In this case, the instant it becomes obvious that the receivable cannot be collected, bad debt is immediately documented in the accounts. The balance of accounts receivable is reduced by the amount of the year’s written-off bad debt. When a provision for bad debts is exceeded by actual bad debt amounts, then the difference is shown as an expenditure in the income statement of the relevant financial year. This lowers the company’s net earnings for that specific accounting year.  When a company believes it will not be able to recover of  receivables, it will write off the account as a bad debt. Payments for bad debts that have previously been written off will be recorded in the bad debt recovery account if they are ultimately received. As an alternative, businesses might record the payment received and undo the prior transaction at the time of writing off the bad debt.

Estimating Bad Debts:

Companies are required to estimate their bad debt payments in the year when credit sales were made, by the accounting principle of “matching.” 

When allowance is created first time in the accounts it goes directly into the profit and loss statement as an expense. For future periods, an increase in allowance is treated as an expense and a decrease as an income. 

For Example:

Charles Andy has a total receivables balance outstanding on 31st December 20X6 of $500,000. He believes that about 10% of these balances will not be paid and wishes to make an appropriate allowance. His last year’s allowance was $30,000.

What is the bad and doubtful debt expense and SOFP extract for the year end 31st December 20X6? 

SOLUTION:

There is an increase in allowance of $20,000 which will be reported in the statement of profit and loss. Also, net receivables of $450,000 ($500,000 – $50,000) will be reported in the SOFP as at 31st December 20X6. 

How To Deal With Bad Debts:

Even after taking precautions, doing thorough background checks, and setting credit restrictions, some invoices could still go unpaid. The main ways to deal with bad debts are highlighted below:

• It is advisable to promptly follow up once a client doesn’t pay an invoice by sending them automated frequent reminders in the form of bad debt letters or periodic phone calls to speed up collection.
• In order to speed up payments, you may also provide payment plans to clients who are having trouble.
• Debt collection companies may be a useful tool for collecting payments when reminders are unsuccessful. These organizations are equipped with the tools and know-how to pursue unpaid clients.

Aged Debtor Analysis :

A company’s accounts receivables are categorized in a periodic report called a “aged debtor analysis” based on how long an invoice has been unpaid. It serves as a barometer to assess the stability and dependability of a company’s customers.

If an organization’s receivables are being collected considerably more slowly than usual, this may indicate that business is slowing down or that the organization is taking on more credit risk in its sales operations.

Aged debtor analysis is useful in determining the allowance for doubtful accounts.

Frequently Asked Questions (FAQs):

Q1. What Is Bad Debt in Accounting?

ANS. Bad debt is debt that creditor companies and individuals can write off as uncollectible.

Q2. What Is Bad Debt Considered?

ANS. Bad debt is considered a normal part of operating a business that extends credit to customers or clients. Companies should estimate a total amount of bad debt at the beginning of every year to help them budget for that year and account for uncollectible receivables.

Q3. What Type of Asset Is Bad Debt?

ANS. Bad debt is a contra asset, which reduces a business’s accounts receivable.

Written by Tazeem Shahid – student at Mirchawala Hub Of Accountancy