0452 · 4.4Irrecoverable debts and allowance for irrecoverable debts

Trade receivables and debt basics

0:00Nadia’s Cycle Repairs has completed work for customers who agreed to pay later. Some customers will pay, but one has disappeared without settling the bill. Another customer’s payment is uncertain rather than definitely lost. This video covers the meaning of irrecoverable debts and irrecoverable debts recovered. It also covers the need for an allowance for irrecoverable debts, and the journal entries and accounts that record each one. Assets are resources owned or controlled by a business that bring future benefit.

0:26Money that Nadia expects to collect from her customers is one of her assets. Trade receivables are amounts owed by credit customers who have not yet paid for goods or services. When collection becomes uncertain, the accounting records must show the amount likely to be received. Revenue is the income a business earns from its main activity, such as selling goods or providing services. A credit sale records revenue before the customer pays.

0:51Expenses are the costs used up in running the business and earning revenue during a period. Failure to collect the money therefore creates an expense rather than cancelling the original sale. Profit is the amount by which revenue exceeds expenses for a period. Double entry means every transaction is recorded as a debit in one account and a credit of the same amount in another. A debit is an entry on the left side of an account, while a credit belongs on the right.

1:16Each credit entry in a customer’s account reduces the amount that customer owes. A balance is the difference between the debit and credit totals of an account. A customer’s account normally has a debit balance because the customer owes money.

Writing off irrecoverable debts

1:29Irrecoverable debts are amounts owed by customers that the business considers uncollectable. The business decides such an amount will never be paid, for example because the customer is bankrupt or has disappeared. Writing off the amount means removing it from the customer’s account and recording it as an expense. The business no longer expects that particular amount to produce a future benefit. On the thirty-first of December, twenty twenty-seven, Nadia decides that the one thousand dollars Mason owes will never be paid.

1:56The general journal records transactions that do not belong in the other books of prime entry. No money moves in a write-off, so it is recorded there first. A journal entry is a dated record showing accounts to debit and credit, amounts and an explanatory narrative. Debit the irrecoverable debts account because the business has an extra expense, and credit Mason’s account because the amount he owes falls. A ledger is a collection of accounts, and each account records changes relating to one particular item.

2:24Mason’s account opened on the first of January, twenty twenty-seven, with a debit balance of one thousand dollars brought down. The details column names the other account involved, so each record points towards its matching entry. The credit entry on the thirty-first of December therefore names irrecoverable debts. Both sides total one thousand dollars, so Mason’s closing balance is zero. Financial statements are summaries that show a business’s profit or loss for a period and what it owns and owes at a date.

2:52At the year end, the irrecoverable debts expense is transferred to one of them. The statement of profit or loss is the financial statement that shows the revenue, expenses and profit or loss for a period. Mason’s one thousand dollars is added to the expenses of twenty twenty-seven, so profit falls by that amount. The irrecoverable debts account shows a debit of one thousand dollars, with Mason in the details column.

3:14To transfer it, debit the statement of profit or loss and credit the irrecoverable debts account, each with one thousand dollars. This charges the expense against Nadia’s revenue for twenty twenty-seven. Both sides then total one thousand dollars, and the closing balance is zero.

Irrecoverable debts recovered

3:29Irrecoverable debts recovered are amounts received from customers whose balances had already been written off. Nadia’s Cycle Repairs unexpectedly receives six hundred dollars from Olivia on the third of May, twenty twenty-seven. Olivia’s amount had been written off in an earlier year. Other income is income from activities other than the main one, such as rent received or discount received. Because no new sale takes place, the amount recovered counts as other income rather than revenue.

3:55Before recording the receipt, reinstate the six hundred dollars in Olivia’s account. Debit Olivia’s account because the amount recorded as owed rises, and credit irrecoverable debts recovered because other income increases. Both sides of this journal entry are six hundred dollars. Reinstating the debt means Olivia’s account will show that she finally paid in full. The cash book records receipts and payments of cash and of money through the bank.

4:20Debit the bank account by six hundred dollars because money held there increases, and credit Olivia’s account because her outstanding amount falls. The bank balance brought down on the first of May is two thousand four hundred dollars. Two thousand four hundred plus six hundred equals three thousand dollars. With no other bank movements in this illustration, carry down three thousand dollars on the thirty-first of May. The debit and credit totals both equal three thousand dollars.

4:46Bring down the same debit balance on the first of June. Nadia now holds the recovered money in the bank rather than as an amount outstanding from Olivia. Olivia’s ledger account shows six hundred dollars on the debit side against irrecoverable debts recovered. Its credit side records six hundred dollars against bank on the same date. Both sides total six hundred dollars, and the closing balance is zero. Reinstatement and receipt have cleared the customer’s account without recording another sale.

5:13The irrecoverable debts recovered account has a credit of six hundred dollars on the third of May, with Olivia in the details column. On the thirty-first of December, a debit of six hundred dollars closes the account, and the statement of profit or loss receives the matching credit. Both sides total six hundred dollars. As other income, the recovery raises Nadia’s profit for twenty twenty-seven.

Creating an allowance for debts

5:35An allowance for irrecoverable debts is an estimate of trade receivables that may not be paid. Unlike a definite write-off, this estimate concerns uncertainty about amounts still outstanding. Individual customer accounts remain unchanged because those customers still owe the full amounts. A separate allowance account reduces the total value reported for trade receivables. Prudence means that profits and assets are not overstated, and losses and liabilities are not understated. An allowance stops trade receivables appearing at more than Nadia is likely to collect.

6:05The matching or accruals concept means income and expenses are recorded in the period to which they relate, not when cash is received or paid. The likely non-payment is therefore charged in the year of the credit sales. Both concepts explain the need for maintaining an allowance for irrecoverable debts. The allowance is not money placed in a separate bank account. It is an adjustment to the value reported for amounts owed by customers.

6:29Questions often require a percentage of trade receivables after writing off irrecoverable debts. Remove definite unpaid amounts first, then estimate possible non-payment from the amounts that remain. At the end of twenty twenty-seven, trade receivables before Mason’s write-off are twenty thousand dollars. Twenty thousand minus one thousand leaves nineteen thousand dollars. Nadia requires an allowance of five per cent of that remaining amount. Nineteen thousand multiplied by five per cent gives nine hundred and fifty dollars.

6:58There is no existing allowance, so the whole nine hundred and fifty dollars must be created. After deducting it, nineteen thousand minus nine hundred and fifty equals eighteen thousand and fifty dollars. This is the value reported for trade receivables after the allowance. The individual customers still owe nineteen thousand dollars between them. Debit the statement of profit or loss with the nine hundred and fifty dollars as an expense, and credit the allowance for irrecoverable debts account.

7:24This expense lowers Nadia’s profit for twenty twenty-seven. The allowance account has a credit balance, yet it is not an amount the business owes to anyone. Its balance is deducted from the asset of trade receivables instead. The allowance account shows nine hundred and fifty dollars on its credit side, with the statement of profit or loss in the details column. For balancing, place balance carried down on the smaller side and balance brought down on the opposite side.

7:48The balance carried down of nine hundred and fifty dollars therefore goes on the debit side. Both sides total that amount. On the first of January, twenty twenty-eight, the balance brought down is a credit of nine hundred and fifty dollars.

Adjusting the allowance

8:00Twenty twenty-eight ends with trade receivables of twenty-six thousand dollars after all write-offs. Five per cent of twenty-six thousand gives a required allowance of thirteen hundred dollars. The existing allowance is nine hundred and fifty dollars. Thirteen hundred minus nine hundred and fifty gives an increase of three hundred and fifty dollars. Only the increase is an expense in twenty twenty-eight, because the first nine hundred and fifty dollars was charged a year earlier.

8:25Debit the statement of profit or loss with three hundred and fifty dollars of extra expense, and credit the allowance account. Twenty-six thousand minus thirteen hundred leaves twenty-four thousand seven hundred dollars for reported trade receivables. The credit side starts with nine hundred and fifty dollars brought down on the first of January, twenty twenty-eight. Nine hundred and fifty plus three hundred and fifty equals thirteen hundred dollars. Carry down that balance on the debit side, so both totals equal thirteen hundred dollars.

8:53Bring it down as a credit balance on the first of January, twenty twenty-nine. Nadia’s trade receivables after write-offs are twenty-four thousand dollars at the end of twenty twenty-nine, and she now requires four per cent. Twenty-four thousand multiplied by four per cent gives nine hundred and sixty dollars. The existing allowance of thirteen hundred dollars is now too high. Thirteen hundred minus nine hundred and sixty gives a decrease of three hundred and forty dollars.

9:18Debit the allowance account and credit the statement of profit or loss, each with three hundred and forty dollars. The debit reduces the allowance, and the credit is income for twenty twenty-nine because the earlier estimate exceeded what is now needed. No customer has paid any money as part of this adjustment. Twenty-four thousand minus nine hundred and sixty gives reported trade receivables of twenty-three thousand and forty dollars. On the first of January, twenty twenty-nine, the account opens with a credit balance of thirteen hundred dollars.

9:47Its debit side records three hundred and forty dollars against the statement of profit or loss on the thirty-first of December. The balance carried down is nine hundred and sixty dollars. Three hundred and forty plus nine hundred and sixty equals thirteen hundred dollars, so both totals agree. The credit balance brought down on the first of January, twenty thirty, is nine hundred and sixty dollars. Across the three years, the allowance rises from nine hundred and fifty dollars to thirteen hundred dollars.

10:12It then falls to nine hundred and sixty dollars. In twenty twenty-seven, the whole nine hundred and fifty dollars is an expense because the allowance is new. The charge for twenty twenty-eight is only the increase of three hundred and fifty dollars. Twenty twenty-nine shows the decrease of three hundred and forty dollars as income.

Financial statements and exam recap

10:29A statement of financial position shows assets, liabilities and owner’s equity at a particular date. Current assets are assets expected to be turned into cash or used up within twelve months. Nadia’s trade receivables of twenty-four thousand dollars appear under current assets, with the allowance of nine hundred and sixty dollars deducted on the next line. The net figure is twenty-three thousand and forty dollars. Common examination mistakes concern the difference between the closing allowance and the current year’s adjustment.

10:58Deduct the full closing allowance from trade receivables, but charge or credit only its change to the statement of profit or loss. Always calculate the percentage after definite write-offs. Keep customer balances unchanged when adjusting an allowance, because the amounts legally owed have not changed. Paper One contains forty multiple-choice questions, while Paper Two contains five compulsory structured questions. Calculate means work out from given figures, and prepare means present information in a suitable format.

11:26A Paper Two question may ask you to calculate an allowance or prepare journal entries and ledger accounts. Explain means give reasons, why and how, supported by evidence. A structured question gives Nadia’s twenty twenty-nine figures and asks you to calculate the required allowance and explain the effect of its adjustment. Four per cent of twenty-four thousand dollars gives a required allowance of nine hundred and sixty dollars. The allowance falls by three hundred and forty dollars, so this decrease is credited to the statement of profit or loss as income.

11:57Profit for twenty twenty-nine therefore rises by three hundred and forty dollars, although no cash has been received. A definite unpaid amount is written off as an expense and removed from the customer’s account. Money recovered later is other income, with reinstatement followed by the receipt. An allowance estimates possible non-payment without changing individual customer balances. Create the full initial allowance, record only later increases or decreases, and deduct the closing balance from trade receivables.