Introduction to Accounting

Unit 10 :
Bad debts, provision for doubtful debts,
provision for discount on debtors
 Objectives
After you have studied this chapter, you should:
Understand the difference between bad debts and
provision for bad debts
How bad debts can be written off
Make provision for bad and doubtful debts
Calculate and make provision for discount on debtors
Record accounting for bad debts’ recovery
In search for a profit some may
become blind.
 Businesses usually sell goods for cash or
on credit.
 When they sell goods on credit, their
customers become their debtors.
 Companies open personal accounts for
those customers who owe them money
for the products purchased.
.

What are accounts receivables?

Amounts owed by other
companies or persons for goods,
or services provided.

They are as current

reported in the
Balance Sheet
assets
Issues associated with Accounts
Receivables
Granting credits entails both costs and
benefits.
When a company extends credit, it
experiences boost in sales.
However, the cost of Accounts
Receivables is the delay in receiving
payment.
Will my debtors on Accounts
Receivables pay me back or
not? When will they pay?
 Bad Debts

 Some debtors of the company may not be

able to always honor their commitments.
 The most significant cost of Accounts
Receivables is uncollectible accounts or bad
debts.
When the business cannot collect back
the money from the debtors, the debt is
said to be 'bad'. When the debt becomes
bad, it has to be written off.
What makes companies not pay?
A) goods delivered were damaged;
B) the customer claims that he has not
received all items on the invoice;
C) the debtor’s business has failed and the
company has been closed;
D) the debtor may be in short of money;
……..
 Measurement of uncollectible
Accounts
ABC company has credit sales of $100,000
during 2006.
Collections during 2006 were $60,000.
On December 31, 2006 AR are $40,000.
During 2006 there were not bad debts.
 However, 40% of the year’s sale are still
unpaid, and some may never be paid.
Company’s challenges
How should ABC account for their
Accounts Receivables?
Will it collect all Accounts Receivables?
If they think that some of the accounts
will not be collected, which accounts are
they?
Determining the true value of
Accounts Receivables
Two methods are used in accounting for
uncollectible accounts:
1) the direct write-off method (specific
write-off method);
2) the allowance method;
Direct write-off method
Used by companies that rarely experience
problems with collecting debts;
If uncollectibles are small and infrequent,
this practice does not misstate the
economic situation in a material way;
Direct write-off method in
practice
With our previous example, let’s assume
that only two customers were not able to
pay (Mr. James Bond and Mr. Bill
Brown).
The company uses the direct write-off
method for uncollectible debts on AR.
So, they write-off $2,000 in 2007. (the
year after)
Direct write- Assets Liabilities Capital
off method

2006 Sales +$100,000 +$100,000

(increase AR) (increase sales)

2007 Write- -$2,000 -$2,000

off (decrease AR) (increase Bad
Debts expense)
 Accounting treatment of Bad Debts

When a bad debt is to be written off, the entry is:

a) Dr Bad Debt $2,000
Cr Debtor’s account $2,000
Income statement (extract) for the ending
31 December 2008
Gross Profit xxx
Less Expenses:
Bad debts ($2,000)
Direct write-off method
CBB company writes off M.E. Doran’s
$200 balance as uncollectible.
Dr. Bad debts expense 200
◦ Cr AR – M.E. Doran 200

AR are recorded at its gross amount.

What are the drawbacks of the
Direct-off method?
It fails to apply the matching principle of
accrual accounting;
Matching requires recognition of the bad
debts expense at the same time as the
related revenue;
So, when using this method, we overstate
our income of 2006 year;
We understate our income of 2007 year;
Matching principle
Our Expenses must follow our
Revenues.
Our efforts should be matched with our
accomplishments.
 Direct write-off method: Matching applied
Matching violated correctly

Sales 2006 2007 2006 2007

Revenue $100,000 0 $100,000 0

Bad debts 0 $2,000 $2,000 0

expense
Allowance method
As Direct-off method violates the
matching principle and bad debts are
neither small nor similar from year to
year, accountants use the method of
allowances.
 Doubtful Debts
 Financial Statements - Trading a/c, P/L
a/c and Balance Sheet, are prepared at
the end of the year to ascertain the Net
profit and the value of the assets and
liabilities at the end of the year.
As companies do not know which of the
debtors will not pay, they try to estimate
the amount of future non payments in
advance.
So, these predicted debts are called as
doubtful debts.
Businesses are to make provisions (also
named as allowances) for doubtful debts.
Specific features of the allowance
method
It is an estimate of the accounts that will
become uncollectible;
It is a contra account, which contains the
estimated uncollectible amount;
This amount is deducted from the total
accounts receivables;
The other names of this method are
as follows:
Allowance for doubtful accounts
Allowance for bad debts
Reserve for doubtful accounts
Benefits of the allowance method

We recognize bad debts in general during

the proper period, before we identify
specific uncollectible accounts from
specific individuals in the following year.
Suppose, ABC company from its past
experience knows that it will not collect
2% of sales.
$100,000x2%=$2000;
Now is uses Allowance method;
Allowance method Assets = L-ty Capital

2006 Sales +100,000 +100,000

(increase AR) (increase sales)

2006 Allowance -$2,000 -2,000

(Increase allowance for (increase Bad
uncollectible accounts) debts expense)

2007 Write-off +$2,000 No effect

(Decrease in allowances
for uncollectible
accounts)

-$2,000
(Decrease Accounts
Receivables)
 Accounting Entries for Doubtful
Debts
1) 2006 Dr AR $100,000
Cr Sales $100,000
2) 2006
Dr Bad debts expense $2,000
Cr Provision for doubtful debts $2,000
3) 2007
Dr Provision for doubtful debts $2,000
Cr. Account Receivable $2,000
 Balance sheet as at December,
31,2006 (extract)
Accounts Receivables $40,000
Less: Provision
for doubtful debts $2,000
Net Accounts Receivable $38,000
 Methods of Estimating Bad Debts
Percentage of Credit Sales Method
(it provides better matching of expenses
with revenues – an income statement
viewpoint)
Aging of Accounts Receivable Method
(it produces the better estimate of cash
realizable value – a balance sheet
viewpoint)
 Methods of Estimating Bad Debts
Applying the allowance method using a
percentage of Accounts Receivables.
Companies use their historical experience but
estimates are based on year-to-year
uncollectible debts.
 AR at end of Bad debts deemed uncollectible and
Year written off in subsequent year

2001 100,000 3,500

2002 80,000 2,450

2003 90,000 2,550

2004 110,000 4,100

2005 120,000 5,600

2006 112,000 2,200

Six-year total 612,000 20,400

====== =====
Average 102,000 3,400
(divide by 6) ====== =====
Average percentage not collected = 3,400/102,000=3,33%
Aging of Accounts Receivable
Method
We age each customer’s account by
separating the total amount owed by
each customer into aging categories.
These aging categories are based on the
number of days that have passed since
uncollected amounts were first
recorded in the account.
Applying the allowance method
using the percentage of sales
We express the amount of bad debts as
a percentage of total sales.

This method relies on historical

relationships between credit sales and
uncollectible debts.
Next, based on past experience, the
business estimates the percentage of
uncollectible accounts in each time
category.
Then multiply these percentages by the
appropriate column totals.
The column totals are then added to
arrive at the total estimate of
uncollectible accounts
Record the year-end adjusting entry
customer Total Number of days unpaid
0-30 32-60 61-90 over 91
ABS company 700

KG company 1,900 1900

Delta Company 2,200 2,200

TB company 6,000 6,000

Zeta company 1,800 1800

KLM company 600 600

Total 13,200

% Uncollectible 2% 4% 8% 10%

Estimated 938 38 124 176 600

uncollectible amount
Remember,
Whatever method the company uses to
estimate the value of bad debts, the
recording is the same:
Dr. Provision for doubtful debts
Cr. Accounts Receivable
(individual debtor’s account)
(both accounts are decreased)
Bad debts recoveries
Bad debts are recovered, when a customer
pays an account that a company has
previously written off.
Recording bad debt recovery
1) Dr. AR $600
Cr. Sales $600
(we record the sales of $600 to Monterro,
our specific customer )
2) Feb, 2002
Dr. Allowance for doubtful debts $600
Cr. Accounts Receivable $600
(to write-off uncollectible account of
Monterro)
3) Oct. 2002
Dr. Accounts receivable $600
Cr. Bad debt recovery account $600
(to reverse February 2002 write-off of account
of Monterro)
4) Dr. Cash $600
Cr. Account Receivable $600
(to record the collection on account)
Accounting Entries for Recovery of Bad Debts

 Mr. A, whose account was written off

previously pays his debt of $2,000.
 1) Cash a/c Dr 2,000
Mr. A's a/c 2,000
 2) Mr. A's a/c Dr 2,000
Bad debt recovery a/c 2,000
 3) Bad debt recovery a/c 2,000
P/L a/c 2,000
At the end of the financial year, the
credit balance in the bad debts
recovered account is transferred either
to the bad debts account or direct to the
credit side of the profit and loss
account.
Increase or Decrease in Provision for Doubtful
Debts

 Year 2006 provision for doubtful debts

is $200
 Year 2007 provision for doubtful debts
is $500
 Year 2008 provision for doubtful debts
is $400
Solution:
 2006
 Dr. P/L a/c 200
 Provision for doubtful debts 200
 2007
 (There is an increase in provision)
 Dr. P/L a/c 300
 Provision for doubtful debts 300
 2008
 (There is a decrease in provision)
 Provision for doubtful debts 100
 Cr. P/L a/c 100
 After the initial provision is made, any increase or decrease is made to
this figure year after year, depending on the amount required at that
year-end.
Thank you

The End

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