Irrecoverable debts, recovered debts and the allowance for irrecoverable debts

Last time

Before we start: last time, in Capital and revenue items, and valuing inventory, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

When customers do not pay

A business sells on credit, and some customers never pay. Their debts must be written off. And because some of today's debts will probably go bad, a prudent business also makes an allowance in advance. This lesson covers both.

Irrecoverable debts

An irrecoverable debt is a debt that will never be paid, for example because the customer has gone bankrupt or disappeared. It is written off: debit the irrecoverable debts account, an expense; credit the customer's account. At the year end, the total is charged to the income statement, reducing profit.

Debts recovered

Sometimes a written-off customer later pays. The debt is first reinstated: debit the customer, credit irrecoverable debts recovered. Then the payment is recorded as usual: debit the bank, credit the customer. Reinstating first keeps a full record of the customer's history.

Why an allowance?

Some of the trade receivables at the year end will probably not be paid, though we do not know which yet. The prudence concept says losses should be provided for as soon as they are likely. So a business makes an allowance for irrecoverable debts. It is often a percentage of trade receivables, based on past experience.

Creating the allowance

Trade receivables are 8,000 dollars, and the allowance is 5 per cent: 400 dollars. Last year's allowance was 300, so only the increase, 100 dollars, is charged to the income statement. If the allowance falls, the decrease is added to profit.

In the statement of financial position

Trade receivables are shown less the allowance: 8,000 minus 400 is 7,600 dollars. This shows receivables at the amount the business expects to collect. The allowance account itself keeps the full balance of 400, carried down each year.

The entries

Here are the entries for each event.

Effect on the financial statements

Writing off a debt reduces profit and reduces trade receivables. Increasing the allowance reduces profit and reduces net receivables, but does not change cash. A debt recovered increases profit, and increases cash when it is paid.

Why set up an allowance?

A question asked why a business should set up an allowance, other than to follow accounting principles. It gives a more realistic view of how much money will actually be collected, for planning cash flow. And it spreads the cost of bad debts into the year the sales were made, so profit is not overstated.

Mistakes that lose marks

Mistake one: charging the whole new allowance to the income statement instead of only the change. Mistake two: crediting the irrecoverable debts account when writing off. It is debited, as an expense. Mistake three: saying the allowance reduces cash. The fix: charge only the change, and the right entries.

The full-marks tip

The full-marks tip: charge only the increase or decrease in the allowance to the income statement. Show trade receivables less the full allowance in the statement of financial position.

On one card

So, on one card: irrecoverable debts. Keep it for revision.