Introduction to Accounting

Unit 10 : Bad debts, provision for doubtful debts, provision for discount on debtors

Objectives
y y y y y y

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.

y y y

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 ar account r cei ables? recei
Amounts owed by other companies or persons for goods, or services provided.

They are reported in the Balance Sheet

as current assets

Issues associated with Accounts Receivables
Granting credits entails both costs and benefits. y When a company extends credit, it experiences boost in sales. y However, the cost of Accounts Receivables is the delay in receiving payment.
y

Will my debtors on Accounts Receivables pay me back or not? When will they pay?

Bad Debts

y

y

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.

y

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; y B) the customer claims that he has not received all items on the invoice; y C) the debtor¶s business has failed and the company has been closed; y D) the debtor may be in short of money; y ««..
y

Measurement of uncollectible Accounts
ABC company has credit sales of $100,000 during 2006. y Collections during 2006 were $60,000. y On December 31, 2006 AR are $40,000. y During 2006 there were not bad debts. y However, 40% of the year¶s sale are still unpaid, and some may never be paid.
y

Company¶s challenges
How should ABC account for their Accounts Receivables? y Will it collect all Accounts Receivables? y If they think that some of the accounts will not be collected, which accounts are they?
y

Determining the true value of Accounts Receivables
Two methods are used in accounting for uncollectible accounts: y 1) the direct write-off method (specific write-off method); y 2) the allowance method;
y

Direct write-off method writeUsed by companies that rarely experience problems with collecting debts; y If uncollectibles are small and infrequent, this practice does not misstate the economic situation in a material way;
y

Direct write-off method in writepractice
With our previous example, let¶s assume that only two customers were not able to pay (Mr. James Bond and Mr. Bill Brown). y The company uses the direct write-off method for uncollectible debts on AR. y So, they write-off $2,000 in 2007. (the year after)
y

Direct write- Assets off method 2006 Sales +$100,000 (increase AR)

Liabilities

Capital

+$100,000 (increase sales) -$2,000 (increase Bad Debts expense)

2007 Writeoff

-$2,000 (decrease AR)

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 Less Expenses: Bad debts

xxx ($2,000)

Direct write-off method writeCBB company writes off M.E. Doran¶s $200 balance as uncollectible. y Dr. Bad debts expense 200
y

Cr AR ± M.E. Doran AR are recorded at its gross amount.

200

What are the drawbacks of the DirectDirect-off method?
It fails to apply the matching principle of accrual accounting; y Matching requires recognition of the bad debts expense at the same time as the related revenue; y So, when using this method, we overstate our income of 2006 year; y We understate our income of 2007 year;
y

Matching principle
Our Expenses must follow our Revenues. y Our efforts should be matched with our accomplishments.
y

Direct write-off method: Matching violated
Sales Revenue Bad debts expense 2006 $100,000 0 2007 0 $2,000

Matching applied correctly
2006 $100,000 $2,000 2007 0 0

Allowance method
y

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
y

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. y So, these predicted debts are called as doubtful debts. y Businesses are to make provisions (also named as allowances) for doubtful debts.
y

Specific features of the allowance method
It is an estimate of the accounts that will become uncollectible; y It is a contra account, which contains the estimated uncollectible amount; y This amount is deducted from the total accounts receivables;
y

The other names of this method are as follows:
Allowance for doubtful accounts y Allowance for bad debts y Reserve for doubtful accounts
y

Benefits of the allowance method
y

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. y $100,000x2%=$2000; y Now is uses Allowance method;
y

Allowance method

Assets =

L-ty

Capital

2006 Sales

+100,000 (increase AR) -$2,000 (Increase allowance for uncollectible accounts) +$2,000 (Decrease in allowances for uncollectible accounts) -$2,000 (Decrease Accounts Receivables)

+100,000 (increase sales) -2,000 (increase Bad debts expense)

2006 Allowance

2007 Write-off

No effect

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 Less: Provision for doubtful debts Net Accounts Receivable $40,000 $2,000 $38,000

Methods of Estimating Bad Debts
Percentage of Credit Sales Method (it provides better matching of expenses with revenues ± an income statement viewpoint) y Aging of Accounts Receivable Method (it produces the better estimate of cash realizable value ± a balance sheet viewpoint)
y

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 Year 2001 2002 2003 2004 2005 2006 Six-year total 100,000 80,000 90,000 110,000 120,000 112,000 612,000 ======

Bad debts deemed uncollectible and written off in subsequent year 3,500 2,450 2,550 4,100 5,600 2,200 20,400 ===== 3,400 =====

Average 102,000 (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. y These aging categories are based on the number of days that have passed since uncollected amounts were first recorded in the account.
y

Applying the allowance method using the percentage of sales
y

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.

y

Next, based on past experience, the business estimates the percentage of uncollectible accounts in each time category. y Then multiply these percentages by the appropriate column totals. y The column totals are then added to arrive at the total estimate of uncollectible accounts y Record the year-end adjusting entry
y

customer

Total

Number of days unpaid 0-30 32-60 61-90 over 91

ABS company KG company Delta Company TB company Zeta company KLM company Total % Uncollectible Estimated uncollectible amount

700 1,900 2,200 6,000 1,800 600 13,200 2% 938 38 4% 124 8% 176 10% 600 1800 600 1900 2,200 6,000

Remember,
y

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
y

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
y y

y

y

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
y y y

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:
y y y y y y y y y y y y

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 En
8-48

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