Topic 10 - Bad debts and Provisions for Bad Debts
In this chapter, we will consider what a company should do in the situation where an
accounts receivable does not pay his debt, or where there is some doubt about the eventual
payment of all or part of the debt.
An irrecoverable (bad) debt is where we are reasonably certain that the receivable is not
going to pay. For example, the customer may have died leaving no assets, or may have
disappeared without trace.
A doubtful debt (provision for bad debt) is where we are worried that the receivable might
not pay. For example, the debt may have been outstanding for some time and the customer
may not be replying to letters.
Treatment in the financial statements
It is important that we do not overstate assets in the SFP (that we apply the prudence
concept) and that therefore we should only show the receivables that we feel confident will
pay.
Equally, if we realise that we might not receive payment (and therefore lose money) we
should show this as an expense in the Income Statement as soon as doubt arises.
As a result the treatment is as follows:
Irrecoverable debts:
These are removed completely and will no longer appear as part of accounts receivables.
Doubtful debts:
We will leave the debt outstanding as part of accounts receivable (because we are still trying
to collect the money), but we will deduct from receivables and ‘allowance for receivables’
equal to the amount of any doubtful ones, so that the net figure left in the SFP is the total
receivables for which we foresee no problem.
Specific allowance for receivables:
This is an allowance for particular (or specific) debts, where we know that there is a problem
(for example, the debt has been owing for a long time).
General allowance for receivables:
It may be that in our company it is the nature of the business that on average (say) 5% of
our debtors end up not paying. However, it may be that at the year end, all of the individual
debts are reasonably recent and we have no way of identifying which particular customers
will end up not paying. We do feel, however, that probably 5% of them will not pay. Again,
, to be prudent, we will deduct 5% form receivables to leave only the amount we are
reasonably certain of. As this 5% does not relate to any specific customer, we call it a
general allowance for receivables.
In all cases, the cost of removing irrecoverable debts and of allowing for doubtful debts is
charged as an expense in the Income Statement.
Example 1
At the end of the first year of trading there is a balance on the receivables account of Fita of
Rs 62,500. On investigation, this amount is found to include two debts from A plc and B plc
which are to be regarded as irrecoverable. The amounts owing are Rs 2,500 and Rs 1,600
respectively. In addition there is Rs 2,800 owing from Z plc which is regarded as doubtful.
Fita has a policy of maintaining a general allowance for receivables of 4%
Show extracts from the Statement of Financial Position and Income Statement of Fita.
Answer to Example 1
Statement of Financial Position
Rs
Current assets:
Receivables (W1) 58,400
Less: Allowance for receivables (W2)
(5,024)
53,376
Income Statement
Expenses;
Irrecoverable debts (2,500 + 1,600) 4,100
Increase in allowance for receivables 5,024
9,124
(W1) Receivables : 62,500 - 2,500 - 1,600 = Rs 58,400
(W2) Allowance for receivables:
Specific 2,800
General (4% X (58,400 -
2,800) 2,224
5,024
In this chapter, we will consider what a company should do in the situation where an
accounts receivable does not pay his debt, or where there is some doubt about the eventual
payment of all or part of the debt.
An irrecoverable (bad) debt is where we are reasonably certain that the receivable is not
going to pay. For example, the customer may have died leaving no assets, or may have
disappeared without trace.
A doubtful debt (provision for bad debt) is where we are worried that the receivable might
not pay. For example, the debt may have been outstanding for some time and the customer
may not be replying to letters.
Treatment in the financial statements
It is important that we do not overstate assets in the SFP (that we apply the prudence
concept) and that therefore we should only show the receivables that we feel confident will
pay.
Equally, if we realise that we might not receive payment (and therefore lose money) we
should show this as an expense in the Income Statement as soon as doubt arises.
As a result the treatment is as follows:
Irrecoverable debts:
These are removed completely and will no longer appear as part of accounts receivables.
Doubtful debts:
We will leave the debt outstanding as part of accounts receivable (because we are still trying
to collect the money), but we will deduct from receivables and ‘allowance for receivables’
equal to the amount of any doubtful ones, so that the net figure left in the SFP is the total
receivables for which we foresee no problem.
Specific allowance for receivables:
This is an allowance for particular (or specific) debts, where we know that there is a problem
(for example, the debt has been owing for a long time).
General allowance for receivables:
It may be that in our company it is the nature of the business that on average (say) 5% of
our debtors end up not paying. However, it may be that at the year end, all of the individual
debts are reasonably recent and we have no way of identifying which particular customers
will end up not paying. We do feel, however, that probably 5% of them will not pay. Again,
, to be prudent, we will deduct 5% form receivables to leave only the amount we are
reasonably certain of. As this 5% does not relate to any specific customer, we call it a
general allowance for receivables.
In all cases, the cost of removing irrecoverable debts and of allowing for doubtful debts is
charged as an expense in the Income Statement.
Example 1
At the end of the first year of trading there is a balance on the receivables account of Fita of
Rs 62,500. On investigation, this amount is found to include two debts from A plc and B plc
which are to be regarded as irrecoverable. The amounts owing are Rs 2,500 and Rs 1,600
respectively. In addition there is Rs 2,800 owing from Z plc which is regarded as doubtful.
Fita has a policy of maintaining a general allowance for receivables of 4%
Show extracts from the Statement of Financial Position and Income Statement of Fita.
Answer to Example 1
Statement of Financial Position
Rs
Current assets:
Receivables (W1) 58,400
Less: Allowance for receivables (W2)
(5,024)
53,376
Income Statement
Expenses;
Irrecoverable debts (2,500 + 1,600) 4,100
Increase in allowance for receivables 5,024
9,124
(W1) Receivables : 62,500 - 2,500 - 1,600 = Rs 58,400
(W2) Allowance for receivables:
Specific 2,800
General (4% X (58,400 -
2,800) 2,224
5,024
