COURSE CODE & NAME: ACT001 - FUNDAMENTALS OF ACCOUNTING

LECTURE NUMBER: 6/Unit 4 (b)

LECTURE TITLE: ADJUSTMENTS AT THE END OF AN ACCOUNING PERIOD
(CONTD.)

Welcome again to Unit 4 of our course. As we mentioned in our last lecture, we will be
covering the second section of Unit 4 in today’s class. Here’s a quick reminder of the
objectives for this unit:
 Adjust nominal accounts for amounts owing and prepaid.
 Show accruals, prepayments and revenue debtors in the balance sheet.
 Explain the need for a charge for depreciation expense.
 Explain the causes of depreciation.
 Calculate depreciation using either the straight line or reducing balance methods.
 Calculate depreciation on assets bought or sold within an accounting period.
 Make adjustments for bad and doubtful debts
 Write up Journal entries for bad debt provisions and write offs.

Recommended Reading:
Chapters 25 - F. Wood & A. Sangster (2012). Business Accounting 1, 12th edition

I. Bad Debts
With many businesses a large proportion, if not all, of the sales are on credit. The
business is therefore taking the risk that some of the customers may never pay for the
goods sold to them on credit. This is a normal business risk and such bad debts are a
normal business expense. They must be charged to the Income Statement as an expense
when calculating the net profit or loss for the period. The other thing that needs to be
done is to remove the bad debt from the asset account. Usually, this will mean closing the
debtor’s account.
When a debt is found to be ‘bad,’ the asset as shown by the debt in the debtor’s account is
worthless. The debt must be eliminated from the account. If doing so reduces the balance
to zero, the debtor’s account is closed.

II. Accounting entries for Bad Debts

To record a bad debt:
1. Credit the debtor’s account to cancel the asset
2. Debit the bad debts account to increase the expense
There is a range of possible scenarios that may exist concerning a bad debt:
 The debtor may be refusing to pay one of a number of invoices;
 The debtor may be refusing to pay part of an invoice;

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  The debtor may owe payment on a number of invoices and indicated that only a
proportion of the total amount due will ever be paid because the debtor’s business
has failed;
 The debtor’s business has failed and nothing is ever likely to be received.
Whatever the reason, once a debt has been declared ‘bad’, the journal entry is the same.
Debit the Bad Debt account with the amount of the bad debt and credit the debtor’s
account in the sales ledger to complete the double entry.
At the end of the period, the total of the bad debts account is transferred to the Income
Statement.

III. Allowance for doubtful debts

When we are drawing up our financial statements, we want to achieve the following
objectives:
 To charge as an expense in the income statement for that year an amount
representing debts that will never be paid;
 To show in the statement of financial position a figure for accounts receivable as
close as possible to the true value of accounts receivable at the date of the
statement of financial position.
Debts declared ‘bad’ are usually debts that have existed for some time, perhaps even
from previous accounting periods.

However, how about other debts that have not been paid by the year end? These may not
have been owing for so long, in which case it will be more difficult to determine which of
them will be bad debts. Nevertheless, as all business experience bad debts at some time, it
is likely that at least some of the other debts will ultimately prove to be bad. The
prudence concept says that this possibility needs to be provided for in the current period,
otherwise both the accounts receivable balance reported in the statement of financial
position and the profit reported in the income statement will almost certainly be
overstated.

It is impossible to determine with absolute accuracy at the year-end what the true amount
is in respect of debtors who will never pay their accounts. So, how do you decide on the
amount of a provision (i.e. an allowance) against the possibility of some of the remaining
debts (after removing those which have been written off as bad) proving bad in a future
period?

In order to arrive at a figure for doubtful debts, a business must first consider that some
debtors will never pay any of the amount they owe, while others will pay a part of the
amount owing, leaving the remainder permanently unpaid. The estimated figure for
doubtful debts can be made:
a. By looking at each debt, and deciding to what extent it will be bad;
b. By estimating, on the basis of experience, what percentage of the total amount
due from the remaining debtors will ultimately prove to be bad debts

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It is well know that the longer a debt is owing, the more likely it is that it will become a
bad debt. Some business draw up an ‘ageing schedule’, showing how long debts have
been owing. Older debtors need higher percentage estimates of bad debts than do newer
debtor. The percentages chosen should reflect the actual pattern of bad debts experienced
in the past.

Accounting entries for allowances for doubtful debts

The accounting entries needed for the allowance for doubtful debts are:
Year in which the allowance/provision is first made:
1. Debit the profit and loss account with the amount of the allowance (i.e. deduct it
from gross profit as an expense)
2. Credit the Allowance for Doubtful Debts Account
There are two different accounts to make the two different types of adjustments to
accounts receivable. This is done in order to make it clear how much is (a) being written-
off as bad debts, and how much is (b) being treated as an allowance for doubtful debts:
1. Bad debts account: This expense account is used when a debt is believed to be
irrecoverable and is written-off.
2. Allowance for doubtful debts account: This account is used only for estimates of
the amount of debt remaining at the year-end after the debts have been written off
that are likely to finish up as bad debts. (This account is also known as the
‘allowance for bad debts account’).
i. Adjusting the balance of the Allowance for doubtful debts Account
The balance of the Allowance for doubtful debts account shows the total estimated
amount of debts that are expected to go bad. Because these are estimates, they may
change from period to period. It is therefore necessary to adjust the balance of the
Allowance for doubtful debt account to reflect these changes. This can be done in the
following steps:
1. Equate the balance carried down (c/d) figure of the Allowance for doubtful debts
account to the total amount of the allowance/provisions to be made for doubtful
debts.
2. Subtract the balance brought down (b/d) figure at the start of the period from the
balance c/d figure.
3. If the difference is positive, it means that the provision has increased. To show
this increase, make a credit entry in the Allowance Account and debit the Profit
and Loss account. If the difference is negative, it means that the provision has
decreased. To show this decrease make a debit entry in the Allowance account
and a credit entry in the Profit and Loss account.

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 ii. Allowance for doubtful debts on the Balance Sheet
In the Balance sheet, the Allowance for doubtful debts balance is deducted from the
Accounts receivable total as follows:

Balance Sheet Extract:

Current Assets $
Accounts Receivable/Debtors 100
Less Allowance for doubtful debts (40)
Net Accounts Receivable 60

Lecture Question

Question 1

B. Walker has opening balances at January 2012 on his debtors account and provision for
doubtful debts account of $1000 and $50 respectively. During the year, B. Walker made
credit sales of $500 and received cash from his debtors of $200.
At December 31, 2012 B. Walker received his debtors listing and acknowledges that he is
unlikely ever to receive debts totaling $20. These are to be written off as bad. B. Walker
also wishes to make provisions for 10% of his remaining debtors after writing off the bad
debts.
You are required to prepare:
(a) The debtors account up to January 1, 2013.
(b) The provision for doubtful debts account up to January 1, 2013.
(c) The bad debt expense account up to January 1, 2013.
(d) The Balance Sheet Extract for 2012.

Self-Assessment/Practice Questions
Question 2

T. Parker has opening balances at January 2013 on his debtors account and provision for
doubtful debts account of $8000 and $50 respectively. During the year, T. Parker made
credit sales of $400 and received cash from his debtors of $150.
At December 31, 2013 T. Parker received his debtors listing and acknowledges that he is
unlikely ever to receive debts totaling $20. These are to be written off as bad. T. Parker
also wishes to make provisions for 20% of his remaining debtors after writing off the bad
debts.
You are required to prepare:
(a) The debtors account up to January 1, 2014.
(b) The provision for doubtful debts account up to January 1, 2014.
(c) The bad debt expense account up to January 1, 2014.
(d) The Balance Sheet Extract for 2013.

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Question 3

H. Williams has opening balances at January 2015 on his debtors account and provision
for doubtful debts account of $800 and $50 respectively. During the year, H. Williams
made credit sales of $400 and received cash from his debtors of $150.
At December 31, 2015 H. Williams received his debtors listing and acknowledges that he
is unlikely ever to receive debts totaling $20. These are to be written off as bad. H.
Williams also wishes to make provisions for 20% of his remaining debtors after writing
off the bad debts.
You are required to prepare:
(a) The debtors account up to January 1, 2016.
(b) The provision for doubtful debts account up to January 1, 2016.
(c) The bad debt expense account up to January 1, 2016.
(d) The Balance Sheet Extract for 2015.

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 Glossary
Terms Meaning
Aging a table that shows a summarized breakup of accounts receivable into
schedule different time brackets. It is an important tool used in working capital
management to project pattern of collections and estimate doubtful debts
Allowance a reserve that is set aside in the expectation of expenses that will be
incurred at a future date. The creation of a reserve essentially
accelerates the recognition of an expense into the current period from
the later period in which it would otherwise have been recognized.
The allowance for bad debts is a reserve against the amount of accounts
receivable that customers may not pay. When actual bad debts are
recognized, they are charged against this allowance account.

Bad debt a receivable that a customer will not pay. Bad debts arise under the
following circumstances: When a company extends too much credit to a
customer that is incapable of paying back the debt, resulting in either a
delayed, reduced, or missing payment. When a customer misrepresents
itself in obtaining a sale on credit, and has no intent of ever paying the
seller.
Debtor an individual or entity that has a legally binding obligation to pay money
to a creditor. The concept can apply to individual transactions, so that
someone could be a debtor in regard to a specific supplier invoice, while
being a creditor in relation to its own billings to customers.
Invoice a document submitted to a customer, identifying a transaction for which
the customer owes payment to the issuer. This document represents an
asset of the issuer and a liability of the customer.
Net profit the result after all expenses have been subtracted from revenues. This
figure is the aggregate result of all operating and financing activities of
an organization. As such, it is routinely relied upon by investors,
creditors, and lenders to make decisions about how to deal with a firm.
Net profit is also called the bottom line, because it is positioned at the
bottom of the income statement.
Sales a detailed itemization of sales made, presented in date sequence. It may
ledger also contain credits issued that reduce the amount of sales, perhaps for
products returned by customers. The information in a sales ledger can
be quite detailed, including such items as the sale date, invoice number,
customer name, items sold, sale amounts, freight charged, sales taxes,
value-added tax, and more.

Other Resources:
https://www.youtube.com/watch?v=E1q8o2jXjsM
https://www.youtube.com/watch?v=9yp3NGs-dag

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References:
http://xplaind.com/119957/aging-schedule
https://www.merriam-webster.com/dictionary/understate
http://www.businessdictionary.com/definition/opening-stock.html
http://www.accountingtools.com/questions-and-answers/what-is-interest-revenue.html
smallbusiness.chron.com/commission-balance-sheet-36570.html