The overall learning objectives associated with this topic include understanding the difference between an irrecoverable debt and a doubtful debt, knowing how to account for both irrecoverable debts (including those recovered), and implementing provisions for doubtful debts. This knowledge is foundational and is consolidated when preparing comprehensive financial statements, such as those for a sole trader or partnership.
Irrecoverable Debts (Bad Debts)
An irrecoverable debt is defined as a debt due from a customer which is expected will never be paid by them. As soon as a debt is known to be irrecoverable (e.g., if a customer becomes bankrupt and is unable to pay), it must be cleared from the sales ledger.
Accounting Treatment:
- Writing Off the Debt: The debt is removed from the specific customer's account in the sales ledger and transferred to an irrecoverable debts account, typically via a journal entry:
- Debit the Irrecoverable Debts account.
- Credit the individual Customer (Debtor) account (in the sales ledger).
- Transfer to Income Statement: When annual accounts are prepared, the total balance on the irrecoverable debts account is transferred to the income statement as an expense.
Irrecoverable Debts Recovered
If a customer later gains sufficient funds and pays a debt that was previously written off as irrecoverable, the recovery must be recorded.
Accounting Treatment:
- Re-establishing the Debt: The debt must be recorded once more on the sales ledger account using a journal entry. The corresponding credit entry is made to an Irrecoverable Debts Recovered account:
- Debit the Customer account.
- Credit the Irrecoverable Debts Recovered account.
- Recording the Cash Receipt: The amount received from the customer is then credited to their account and debited in the cash book.
- Transfer to Income Statement: The balance on the irrecoverable debts recovered account is credited to the income statement. It should be shown under gross profit as other income. It is explicitly advised never to show the amount recovered as a negative expense.
Doubtful Debts and Provisions
A doubtful debt is a debt due from a customer where there is uncertainty whether or not it will be repaid by them.
It would be misleading to include a doubtful debt as a fully recoverable asset in the statement of financial position (SFP). However, because the debt has not yet become definitively irrecoverable, it should not be immediately written off as an expense either. Therefore, a provision for doubtful debts is created to cover these potential losses.
Key Principles and Accounting Entries:
- The creation and maintenance of a provision for doubtful debts is an application of the Prudence concept (preventing the overstatement of expected receivables in the SFP and the overstatement of profit) and the Matching concept (ensuring the potential loss is provided for in the same period the revenue was earned).
- When a provision is initially created, the income statement is debited and a Provision for Doubtful Debts account is credited with the full amount.
- In subsequent years, adjustments are made for changes in the required provision:
- Increases in the provision are debited to the income statement and credited to the provision account.
- Decreases in the provision are debited to the provision account and credited to the income statement. A decrease should be added to the gross profit as other income, never shown as a negative expense.
- In the Statement of Financial Position (SFP), the provision for doubtful debts is deducted from trade receivables.
Methods for Calculating Provision for Doubtful Debts
The calculation depends on the type of provision required, categorized as:
- Specific: Certain debts are individually identified as doubtful (e.g., based on knowledge of the customer's financial position), and the provision is the total of those specific debts.
- General: The provision is calculated as a fixed percentage of the total trade receivables.
- Specific and General: The provision is the sum of the specifically doubtful debts plus a percentage (general provision) calculated on the remainder of the trade receivables.
Important Note on Calculation:
- It is crucial that specific provisions are always deducted from total trade receivables first, before the general provision percentage is applied to the remaining balance.
- You must never refer to a provision for irrecoverable debts; irrecoverable debts should always be written off immediately as they occur.
Adjustments for irrecoverable and doubtful debts are commonly included in comprehensive accounting problems, sometimes affecting administrative expenses in an income statement, and represent an area of accounting where subjectivity and judgment are applied.
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