Irrecoverable Debts and Allowances
1 Introduction
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.
We will examine both the accounting entries and the presentation in the financial statements.
2 Definitions
An irrecoverable 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 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.
(Note that obviously if a customer refuses to pay we are at liberty to take them to court. However, it may be that the costs of going to court will be more than the amount of the debt and that therefore we decide not to do so.)
3 Treatment in the financial statements
It is important that we do not overstate assets in the Statement of Financial Position (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 Statement of Profit or Loss as soon as any 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 receivable.
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 an “allowance for receivables” equal to the amount of any doubtful ones, so that the net figure left in the Statement of Financial Position 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% from 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 Statement of Profit or Loss.
At the end of the first year of trading there is a balance on the receivables account of Street of $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 $2,500 and $1,600 respectively.
In addition there is $2,800 owing from Z plc which is regarded as doubtful.
Street has a policy of maintaining a general allowance for receivables of 4%.
Show extracts from the Statement of Financial Position and Statement of Profit or Loss of Street.
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4 The accounting entries
Each individual entry that can be required is very easy. The problem in examinations results from the fact that there can be many accounting entries required in a question and it is easy to get lost!
We will illustrate the necessary entries using two worked examples.
Cilla started business on 1 January 2000. As at 31 December 2000, the balance on her Receivables Account was $82,000.
On investigation this was found to include the following debts:
John owed $5,000 which is irrecoverable
George owed $8,000 and is a doubtful debt
Paul owed $3,000 which is irrecoverable
Ann owed $2,000 and is a doubtful debt
In addition is had been decided to have a general allowance for receivables of 4% of remaining debts.
Write up the Accounts Receivable, Irrecoverable debts Expense, and Allowance for Receivables accounts
Show extracts from Cilla’s Statement of Financial Position and Statement of Profit or Loss
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To be able to illustrate all of the possible entries, we now need to look at the position in the following year.
During the year ended 31 December 2001, Cilla had made sales on credit of $261,000 and had received cash from customers of $238,000.
These amounts had been entered into the Receivables Account, and a balance extracted.
On investigation, the following was discovered:
Paul had paid $2,200 of his previously irrecoverable debt (we do not expect to receive any more)
George had still not paid the $8,000 owing, and must now be regarded as irrecoverable
Ann had paid her debt of $2,000 in full
Ringo was owing $4,000 which is irrecoverable
Mick was owing $6,000 and is a doubtful debt
It was decided to maintain the general allowance for receivables at 4% of the remaining debts
(Note: the amounts received from Paul and Ann are included in the total cash receipts for the year of $238,000)
Write up the Accounts Receivable, Irrecoverable Debts Expense, and Allowance for Receivables accounts
Show extracts from Cilla’s Statement of Financial Position and Statement of Profit or Loss
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Irrecoverable Debts and Allowances
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