Accounting for bad and doubtful debts

Accounting for bad and doubtful debts

Honey, Ann

Ann Honey explains the difference between bad and doubtful debts, an important topic in the ICM examinations.

As credit people, it will be extremely unlikely if we have not come across a bad debt at some time or other. It is at such times that we like to remind ourselves – and others – that you cannot maximise profits without incurring the odd irrecoverable debt or two. Most businesses need to take on marginal business in order to make the expected returns and, unfortunately, we cannot get it right all the time. Customers do go bankrupt and cannot pay us and they do occasionally disappear without trace. It follows then, that credit personnel are likely to be sadly familiar with bad debts and should understand the treatment of them in the accounts. This is why accounting for bad and doubtful debts is an important topic in the Certificate stage ‘Accounting’ paper.

Definition

First let’s distinguish between a bad and a doubtful debt. A debt owing to a business that is not expected to be paid is a bad debt. A doubtful debt is a debt, which the business considers may not be paid. The distinction is important because the accounting treatment differs, as shown below.

Double entry

Bad and doubtful debts torm part ot the double entry bookkeeping system. Note that the general principles of double entry bookkeeping are not covered here but form part of the ICM Accounting unit.

Accounting treatment for bad debts

If we decide that there is no probability of collecting an overdue amount, we need to reduce the balance sitting on that customer’s account to zero. We do not want to show a balance owing that in fact will never be recovered because this would be overstating our debtors and therefore overstating our assets. The amount being written off represents a bad debt and so we transfer this balance to the expense account – `bad debts’.

We then need to reflect this expense in our accounts and therefore transfer the balance to the profit and loss account.

The entries are as follows:

Debit : Bad debt account

Credit : Customer’s account

Transferring to the final accounts:

Debit : Profit and loss account

Credit: Bad debt account.

Acounting treatment for doubtful debts

A doubtful debt may not turn into a bad debt. In fact, it may not be possible to isolate specific customers when computing an amount which may turn bad. Experience may allow us to estimate the level of bad debt that tends to arise in our business. But however we arrive at this figure, prudence dictates that we should provide for this in our final accounts.

The accounting entries will be as follows:

Debit : Profit and loss account

Credit: Provision for bad debts

The provision will be shown on the balance sheet as a deduction from debtors. We are thus reducing the value of debtors to comply with the requirement to show assets at conservative values.

The provision will be increased or decreased in subsequent years depending on the level of debtors and likely level of bad debt determined at the end of the year. Increases to the provision in subsequent years will be debited to the profit and loss account. Decreases in the provision will be credited to the profit and loss account. The provision will be calculated after all bad debts have been written off.

Note that the auditors pay particular attention to bad debt provisions because of the ease with which they can be used to manipulate profit and create a `hidden reserve’.

Let’s now look at an example.

Example

Alice Beeton runs a food and drinks business. Her customers are given 60 days credit. Alice is about to prepare her accounts as at the year ending 30June 2000. Alice has run a number of promotions this year and has determined that the provision for bad debts will need to be increased from 2 per cent to 3 per cent of her debtors. The net debtors for last year were 28, 000. Debtors are currently 32,900.

In addition it bas been decided to write off two overdue debts, wbkb are:

31 March – F 12,500

31 May – A Ward 400

Show all the relevant entries in the accounts.

Suggested solution

Step 1

Currently, the balances that have gone bad are sitting on the customer accounts. These need to be transferred to the bad debts (expense) account.

Step 3

The increase/decrease in provison needs to be calculated. Remember the provision is calculated on the net debtors – ie net of bad debts.

We can now show the provision for bad debts.

Step 4

We can now show the entries in the final accounts. The profit and loss account shows the expenses incurred – the bad debts and increase in the provision for bad debts. The balance sheet shows the asset, ‘debtors’ and the `provision for bad debts’. Note: the balance sheet is not part of the double entry bookkeeping system.

Ann Honey teaches on the Accounting and Credit Management units at London Guildhall University.

Copyright Institute of Credit Management Ltd. Oct 2000

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