Commerce Department Baghdad Campus IUB

BAD AND DOUBTFUL DEBTS

The main reason for granting credit to customers is that allowing credit increases sales. Granting
credit to customers for sales entails costs and benefits. One cost is the possibility that some
debtors will never pay or there is some doubt on the recoverability.
ALLOWANCES FOR DOUBTFUL DEBT Page | 1

Bad debt (also known as Irrecoverable debts or receivables)

When we are certain that debtor will not pay his debt it is termed as bad debt. The business
believes it will never be able to collect. Examples of circumstances that might lead to the conclusion that
a receivable is irrecoverable include:
The bankruptcy or insolvency of a customer.
The death of a customer who has left insufficient assets to pay off his debts.
A dispute with a customer.
The dishonesty of a customer (where he has obtained goods on credit with no intention to pay).
A customer experiencing operational difficulties which might lead to financial problems (for example,
strikes, natural disasters disrupting production etc.).

Doubtful debts
A doubtful debt is an amount owed by a customer that the business believes might prove difficult to
collect but they still hope to do so. For example, the business might know that the customer is in difficulty
but that he might be able to work his way out of it. This casts doubt on the collectability of the receivable
but it still might be possible if the customer is able to recover from his difficulties.
Examples of circumstances that might lead to the conclusion that a receivable is doubtful include:
A customer experiencing cash flow problems.
A customer taking an unusually long time to settle a debt.

Allowances for doubtful debt

It is an estimate that how many debtors will not be able to pay in future. Normal balance of it is
Cr.(favorable). Butt it may also be Dr. (unfavorable). If nothing is mentioned with its balance
we will take it Cr. Balance.

“Matching concept” requires that revenue must be matched against related expenses for a
specific
accounting period. If there is a doubt on recoverability of debt, it should logically become
expense and should be matched against the sales of the accounting period that recognizes this
revenue. From here the concept of estimating the bad debts arises.

“Prudence” Applying the prudence concept i.e. assets must not be overstated, these are also
charged as an expense. However, instead of writing off the debt (which would remove it from the
records) a business sets up an allowance account.
The receivable must stay in the accounting records so that the business continues to chase
payment.
Prudence requires that an allowance be created to recognize the potential loss arising from the
possibility of incurring bad debts. The allowance for doubtful debts is created by forming a credit
balance which is deducted from the total receivables balance in the statement of financial
position.

From the desk of Jahanzaib Butt

Commerce Department Baghdad Campus IUB

Calculation of allowances for doubtful debt

The principal accounting problem is to measure or estimate the amount of debtors who will not
be
able to pay in future. There are three methods of estimating:
1. Debt Review; Page | 2
2. Age analysis; and
3. Percentage of Sales.

1. Debt Review:
Under this method, a sheet is prepared by considering each individual debt. In sheet, debts are
classified into: (1) good debts; and (2) doubtful debts. Allowances are made for doubtful debts
only.

2. Age analysis:
Under this method age of all debtors is calculated, and a higher rate of allowances is applied to
old debtor as compared to the new ones.

3. Percentage of Sales:
Another method of estimating bad debt is based on sales. Under this method, a certain
percentage is applied to net credit sales for calculating allowances.

Accounting treatment
The allowance account (a contra asset account) is a credit balance which is then set against the
carrying amount of the receivables in the statement of financial position. The allowance account
might also be called provision for doubtful debts
The allowance account is estimated periodically and any adjustment is recognised either as an
expense (in case of increase) or as reduction in an expense (in case of decrease).

One of the following two journal entries is recorded at year end:

Creating or increasing the allowance

Bad & doubtful debts expense Dr.
To Allowance for doubtful debts Cr.
Decreasing the allowance
Allowance for doubtful debts Dr.
To Bad & doubtful debts expense Cr.

Note that no additional accounting entry is required when any doubtful debt is recovered as
receivable has not been written off in this case.

A/R Write off Entry (if provision is not created from them i.e write off current year A/R)
Bad & doubtful debts expense a/c Dr.
To A/R a/c Cr.

From the desk of Jahanzaib Butt

Commerce Department Baghdad Campus IUB
A/R Write off Entry (if provision is already created from them i.e write off past year A/R)
Allowances for doubtful debts Dr.
To A/R Cr.

Page | 3
BAD DEBT RECOVERY
When debtor does not pay money, the seller immediately writes it off by debiting Bad Debt
expense account and crediting the debtors account. The customer account shows nil balance
when this entry is passed. Occasionally, debts that have been written off as bad are unexpectedly
collected (generally in a subsequent accounting year). When any bad debts is recovered, any of
following the accounting entry is passed:

Bad debt recovery income

i) A/R Dr.
To Bad Debt recovery income account Cr.

ii) Cash Dr.

To A/R Cr.

Bad debt recovery income will be shown under the head „other income‟ while preparing profit
and loss.
OR
Alternatively bad debt recovered may be treated as follow
Bad debt recovery (Reduction in Bad Debts expense a/c)
i) A/R Dr.
Bad & doubtful debts expense a/c Cr.

ii) Cash Dr.

To A/R Cr.
STEP WISE APPROACH FOR SOLVING THE QUESTIONS
Steps to be performed in provision for doubtful debt question
Step 1 Prepare adjusted debtors A/C starting from unadjusted closing balance and
passing the year end adjustments.
Step 2 Prepare the Bad debts expense A/C.
Step 3 Calculate the debtors on which general provision is to be charged
Step 4 Calculate the closing balance of provision (including specific and general)
post in the provision account.
Step 5 Pass the adjusting Entry of increase or decrease in provision A/C.

Practice Question:
Zainab Butt Ltd. Has provided you the following details.
1-07-2020 Allowances for Bad Debts Rs. 10,000
30-06-2021 Debtors (Unadjusted Bal.) Rs. 400,000
1. During the year debtors of Rs. 40,000 needs to be written off and out of these debtors Rs.
15,000, allowances for bad debts maintained in previous year.

From the desk of Jahanzaib Butt

Commerce Department Baghdad Campus IUB

2. Zainab Butt’s policy is to maintain 5% allowances for doubtful debts at year end.
3. Zainab Butt closes its books at 30th June every year.
Required:
1. Prepare A/R a/c, Allowances for bad debts a/c, Bad Debt Expense a/c
2. Extracts for SOCI and SOFP.
Page | 4

From the desk of Jahanzaib Butt