- This topic has 5 replies, 2 voices, and was last updated 3 years ago by
.
- Posts
- Topics: 10
- Replies: 18
- ☆
Hi there, I hope you’re well.
I have a couple of queries about how exactly we treat bad and doubtful debts, using the indirect method in calculating working capital for operating activities.
The problem I have is, if we incorporate bad and doubtful debts into the receivables balance, then compare receivables with the prior year, we will be misled into believing that receivables have been settled and cash received, and thus to rectify this, we would need to keep the non-cash expense of bad and doubtful debts recorded in the income statement to reverse this.
For example, if in 2021 I had receivables of £500,000 with bad debts of £10,000 and allowance for receivables of £50,000, then we are left with an end balance of £440,000 – assuming the prior years balance of receivables was £500,000 too, we will be misled into thinking that £60,000 receivables had been settled, and to mitigate this would have to retain the non-cash expense of bad debts and allowance for trade receivables of £10,000 and £50,000 respectively, so that in the cash flows from operating activities this £60,000 working capital will be deducted by a negative balance of £60,000.
Is this the correct approach in dealing with bad and doubtful debts in the statement of cash flows? I only ask as it seems counterintuitive to deal with the issue by acknowledging a non-cash expense, when the idea of the statement is to remove all non-cash items.
Thanks, and apologies for posting this question on the wrong forum page earlier.
We do not incorporate bad and doubtful debts into the receivables balance.
Irrecoverable debts (we stopped calling them bad debts many years ago) are removed from the balance on receivables because we are no longer going to receive payment for them.
Doubtful debts do not affect the balance on the receivables account. Instead they are recorded in an allowance for receivables account, and on the SOFP we show the balance on receivables less the balance on the allowance account.
On the statement of cash flows, the relevance of changes in working capital is only to be able to calculate the cash flow from operating activities. The purpose is not to list what cash was received or paid in arriving at this figure. In your example, the actual cash received will have been $0 and the fact that the balance on the receivables account will have increased by $10,000 (because the balance stayed the same despite removing irrecoverable debts of $10,000). Therefore the cash from operating activities is reduced by $10,000. If in addition there is no longer an allowance for doubtful debts of $50,000 (which is what your figures would imply) then this $50,000 will have increased the profit which therefore needs reducing by $50,000 given that it is not a cash flow. So in total the profit needs reducing by $60,000 to arrive at the cash generated from operations.
Rather than mess around with all of the previous paragraph, we just look at the change in the receivables less allowance over the period (which as you say is $60,000) and adjust the profit by this amount. Again, nobody is interested in how the cash flow from operations is actually made up – only with the final figure.
- Topics: 10
- Replies: 18
- ☆
I see, thank you for the help, John. Sorry for using the wrong terminology, I have the vocabulary of my old textbook engrained in my brain.
So in calculating the difference in trade receivables, we focus on what movement in net receivables occurs aside from the deduction of irrecoverable debts and the contra-asset of allowances?
So if this were a hypothetical statement of cash flow, the figure for trade receivables under working capital will be £0, and we deduct the non-cash expenses produced in the income statement for irrecoverable debts and allowances for trade receivables?
Thanks.
No. The only adjustment to the operating profit would be the change in the net receivables of $60,000 as I wrote in the final paragraph of my previous reply. How much of this was due to cash received and how much was due to non-cash items is of no relevance because the net affect would be $60,000 anyway.
- Topics: 10
- Replies: 18
- ☆
Got it, thank you for your support!
- The topic ‘Bad and Doubtful Debts in the Statement of Cash Flows’ is closed to new replies.