Chapter 7: Irrecoverable debts and allowances for receivables

Chapter learning objectives

Upon completion of this chapter you will be able to:

• identify the benefits and costs of offering credit facilities to customers
• explain the purpose of an aged receivables analysis
• explain the purpose of credit limits
• prepare the bookkeeping entries to write off an irrecoverable debt
• record an irrecoverable debt recovered
• identify the impact of irrecoverable debts on the income statement and statement of financial position
• prepare the bookkeeping entries to create and adjust an allowance for receivables
• illustrate how to include movements in the allowance for receivables in the income statement and how the closing balance of the allowance should appear in the statement of financial position.

1 The provision of credit facilities

The majority of businesses will sell to their customers on credit and state a defined time within which they must pay (a credit period). The main benefits and costs of doing so are as follows:

Benefits/costs

Benefits

• The business may be able to enter new markets.
• There is a possibility of increased sales.
• Customer loyalty may be encouraged.

Costs

• Can be costly in terms of lost interest since the business is accepting payment later.
• Cash flow of the business may deteriorate.
• There is a potential risk of irrecoverable debts.

Aged receivables analysis

Where credit facilities are offered, it is normal for a business to maintain an aged receivables analysis.

• Analysis is usually a list, ordered by name, showing how much each customer owes and how old their debts are.
• The credit control function of a business uses the analysis to keep track of outstanding debts and follow up any that are overdue.
• Timely collection of debts improves cash flow and reduces the risk of them becoming irrecoverable.

Credit limits

It is also normal for a business to set a credit limit for each customer. This is the maximum amount of credit that the business is willing to provide.

The use of credit limits may:

• reduce risk to business of irrecoverable debts by limiting the amount sold on credit
• help build up the trust of a new customer
• be part of the credit control strategy of a business.

2 Irrecoverable debts

In this exam you must be prepared to see both the terms 'bad' and 'irrecoverable' debts being used frequently.

• The accruals concept dictates that when a sale is made, it is recognised in the accounts, regardless of whether or not the cash has been received.
• If sales are made on credit, there may be problems collecting the amounts owing from customers.
• Some customers may refuse to pay their debt or be declared bankrupt and unable to pay the amounts owing.
• Some customers may be in financial difficulties or may dispute the amount owed and there may be some doubt as to whether their debt will be paid.
• If it is highly unlikely that the amount owed by a customer will be received, then this debt is known as an irrecoverable debt. As it will probably never be received, it is written off by writing it out of the ledger accounts completely.
• If there is some doubt whether a customer can or will pay his debt, an allowance for receivables is created. These debts are not yet irrecoverable. However the creation of an allowance for receivables means that the possible loss is accounted for immediately, in line with the concept of prudence. The amount of the original debt will still remain in the ledger account just in case the customer does eventually pay.

Receivables and irrecoverable debts

Receivables and irrecoverable debts

If a sale is for cash, the customer pays for the goods immediately the sale is made. If the sale is on credit terms the customer will probably take the goods with him or arrange to have them delivered but he will not pay for the goods at that time. Instead, the customer will be given or sent an invoice detailing the goods and their price and the normal payment terms. This will tell the customer when he is expected to pay for those goods.

Under the accruals concept, a sale is included in the ledger accounts at the time that it is made.

For a cash sale, this will be when the cash or cheque is paid by the customer and the double entry will be:

For a sale on credit, the sale is made at the time that the invoice is sent to the customer and therefore the accounting entries are made at that time as follows:

When the customer eventually settles the invoice the double entry will be:

This then clears out the balance on the customer’s account.

3 Accounting for irrecoverable debts

An irrecoverable debt is a debt which is, or is considered to be, uncollectable.

With such debts it is prudent to remove them from the accounts and to charge the amount as an expense for irrecoverable debts to the income statement. The original sale remains in the accounts as this did actually take place.

The double entry required to achieve this is:

Test your understanding 1

Araf & Co have total accounts receivable at the end of their accounting period of $45,000. Of these it is discovered that one, Mr Xiun who owes $790, has been declared bankrupt, and another who gave his name as Mr Jones has totally disappeared owing Araf & Co $1,240.

Calculate the effect in the financial statements of writing off these debts as irrecoverable.

4 Accounting for irrecoverable debts recovered

There is a possible situation where a debt is written off as irrecoverable in one accounting period, perhaps because the customer has been declared bankrupt, and the money, or part of the money, due is then unexpectedly received in a subsequent accounting period.

When a debt is written off the double entry is:

When cash is received from a customer the normal double entry is:

When an irrecoverable debt is recovered, the credit entry (above) cannot be taken to receivables as the debt has already been taken out of the receivables balance.

Instead the accounting entry is:

Some businesses may wish to keep a separate ‘irrecoverable debts recovered’ account to separate the actual cost of irrecoverable debts in the period.

Test your understanding 2

Celia Jones had receivables of $3,655 at 31 December 20X7. At that date she wrote off a debt from Lenny Smith of $699. During the year to 31 December 20X8 Celia made credit sales of $17,832 and received cash from her customers totalling $16,936. She also received the $699 from Lenny Smith that had already been written off in 20X7.

What is the final balance on the receivables account at 31 December 20X7 and 20X8?

5 Allowance for receivables

There may be some debts in the accounts where there is some cause for concern but they are not yet definitely irrecoverable.

It is prudent to recognise the possible expense of not collecting the debt in the income statement, but the receivable must remain in the accounts in case the customer does in fact pay up.

An allowance is set up which is a credit balance. This is netted off against trade receivables in the statement of financial position to give a net figure for receivables that are probably recoverable.

There are two types of allowance that may appear in the organisation’s accounts:

• There will be some specific debts where the customer is known to be in financial difficulties, is disputing their invoice, or is refusing to pay for some other reason (bad service for example), and therefore the amount owing may not be recoverable. The allowance for such a debt is known as a specific allowance.
• The past experience and history of a business will indicate that not all of its trade receivables will be recoverable in full. It may not be possible to identify the amount that will not be paid but an estimate may be made that a certain percentage of customers are likely not to pay. An additional allowance will be made for these items, often known as a general allowance.

6 Accounting for the allowance for receivables

An allowance for receivables is set up with the following journal:

If there is already an allowance for receivables in the accounts (opening allowance), only the movement in the allowance is charged to the income statement (closing allowance less opening allowance).

As the allowance can increase or decrease, there may be a debit or a credit in the irrecoverable debts account so the above journal may be reversed.

When calculating and accounting for a movement in the allowance for receivables, the following steps should be taken:

(1) Write off irrecoverable debts.

(2) Calculate the receivables balance as adjusted for the write-offs.

(3) Ascertain the specific allowance for receivables required.

(4) Deduct the debt specifically provided for from the receivables balance (be sure to deduct the full amount of debt rather than the amount of specific allowance).

(5) Multiply the remaining receivables balance by the general allowance percentage to give the general allowance required.

%(closing receivables – irrecoverable debts – debts specifically allowed for).

(6) Add the specific and general allowances required together.

(7) Compare to the brought forward allowance.

(8) Account for the change in allowance.

Illustration

On 31 December 20X1 Jake Williams had receivables of $10,000. From past experience Jake estimated that the equivalent of 3% of these customers were likely never to pay their debts and he therefore wished to make an allowance for this amount.

During 20X2 Jake made sales on credit totalling $100,000 and received cash from his customers of $94,000. He still considered that the equivalent of 3% of the closing receivables may never pay and should be allowed for.

During 20X3 Jake made sales of $95,000 and collected $96,000 from his receivables. At 31 December 20X3 Jake still considered that the equivalent of 3% of his receivables should be allowed for.

Calculate the allowance for receivables and the irrecoverable debt expense as well as the closing balance of receivables for each of the years 20X1, 20X2, 20X3.

Solution

Test your understanding 3

John Stamp has opening balances at 1 January 20X6 on his trade receivables account and allowance for receivables account of $68,000 and $3,400 respectively. During the year to 31 December 20X6 John Stamp makes credit sales of $354,000 and receives cash from his receivables of $340,000.

At 31 December 20X6 John Stamp reviews his receivables listing and acknowledges that he is unlikely ever to receive debts totalling $2,000. These are to be written off as irrecoverable. Past experience indicates that John should also make an allowance equivalent to 5% of his remaining receivables after writing off the irrecoverable debts.

What is the amount charged to John’s income statement for irrecoverable debt expense in the year ended 31 December 20X6?

A $2,700

B $6,100

C $2,600

D $6,000

What will the effect be of Irrecoverable debts on both the Income Statement and the Statement of financial position?

Chapter summary

Test your understanding answers

Test your understanding 1

As the two debts are considered to be irrecoverable, they must be removed from receivables:

Note that the sales revenue account has not been altered and the original sales to Mr Xiun and Mr Jones remain. This is because these sales actually took place and it is only after the sale that the expense of not being able to collect these debts has occurred.

Test your understanding 2

The correct answer is A

Test your understanding 3

The correct answer is C

Note that only the one irrecoverable debts expense account is used both to write off irrecoverable debts and to increase or decrease the allowance for receivables. There is no need to use separate accounts for each type of expense.

Working – Allowance for receivables

5% x $80,000 = $4,000

$4000 – b/f 3,400 = movement of 600

The Statement of financial position will show a receivables balance of 80,000. Underneath this separately the allowance for receivables c/f balance of 4,000 will be deducted to give a sub-total of $76,000.

The Income statement will show the $2,600 as an expense. This expense will cause a decrease in overall profits.

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