Bad debts

Bad debtsWhen a business sells to a customer on credit it takes a business risk that the customer might not pay the amount owed.

A business might have to write off the debt as a bad debt.

Bad debts are an expense and will reduce the profit of the business.

A business may decide that the debtor cannot pay or the cost of chasing the debt is not cost effective. The debt will then be written out of the ledger.

How can a business prevent bad debts for new customers?Cash sales or cash on deliveryTrade referencesCredit referencesBank referencesSet a credit limitEarly settlement dates

How can a business prevent bad debts for existing customers?

Send regular statements to debtorsFollow up letterReminder letter with the threat of taking legal actionUsing a third party such as a debt collectorTake legal action in the civil courts

A business could also consider using a factoring firm. The factoring firm would pay the business cash for a proportion of the debtors. The business would not have the problem of chasing debtors for payment.

Accounting entries

Debit - bad debts accountCredit - personal account of the debtor

John Green

Bal b\d 6,000 Bad debts 6,000

Bad debts account

John Green 6,000 Profit and loss a\c 6,000

A debtor may agree to pay some of the debt and the firm will write off the remainder of the debt.John Davy a debtor owes £5,000 and agrees to pay 40 pence in the £. The remainder of his debt will be written off. The following journal entries would be made: Journal Dr Cr

£ £Bad debts 3,000 John Davy 3,000Bank 2,000 John Davy 2,000

Accounting entries

Provision for bad and doubtful debts

A business should make an estimate of the amount of debt that might not be recovered. The accountant will create a provision for doubtful debts in the ledger.When creating a provision the concept of prudence is applied. The profit of the business will not be overstated. Debtors will be shown at a true and fair value in the balance sheet.

Factors to considerwhen creating a provision

Customer historyType of customerSize of the debtGeographical position of the debtorInterest ratesGeneral economic factorsExpert knowledge of the business sector

Factors to considerwhen creating a provisionIt is common practice for a business to produce an analysis of debtors called an aged debtor analysis. This shows the amount of time debts have been outstanding.A business will adopt a practical approach by taking a fixed percentage of debtors. For example the accountants estimate that 5% of the debtors could be bad.Total debtors £500,0005% Provision £25,000The accountants estimate that the asset of debtors is £475,000.

The accounting entries to create a provision for doubtful debtsDebit - profit and loss accountCredit - provision for doubtful debts accountWith the full amount of the provisionTotal debtors £500,0005% provision Provision for doubtful debts account

Bal c\d 25,000 Profit and loss 25,000 25,000 25,000 Bal b\d 25,000

Debtors must be shown in the balance sheet at the net figure.

Balance sheet extractCurrent assets Debtors 500,000Less provision for doubtful debts 25,000 475,000

The prudence concept has been applied and the debtors’ figure is not overstated.

Provision for doubtful debts

The accountant may decide that the provision is not enough and must be increased:

Debit - profit and loss accountCredit - provision for doubtful debts account

only with the amount of the increase

If the total debtors have increased to £800,000 and the business maintains a 5% provision on debtors:

The accounting entries to increase the provision

Provision for doubtful debts account

Bal c\d 40,000 Bal b/d 25,000Profit and Loss 15,000

40,000 40,000Bal b/d 40,000

Current assets

Debtors 800,000 Provision for doubtful debts 40,000 760,000

Entries to increase the provision

The accountant may decide that the provision is too high and will need to be reduced.

Debit - provision for doubtful debts accountCredit - profit and loss accountonly with the amount of the reduction.

This will increase the profit. The amount of the reduction should be added to the gross profit in the trading and profit and loss accounts.If the total debtors reduced to £600,000 and a 5% provision is maintained:

Entries to reduce the provision

Provision for doubtful debts account

Profit and Loss 10,000 Bal b/d 40,000Bal c/d 30,000

40,000 40,000 Bal b/d 30,000

Current assets

Debtors 600,000 Provision for doubtful debts 30,000 570,000

Entries to reduce the provision

A business can produce an analysis of the age of debtors in the business. It can then use the analysis to decide upon:The amount of bad debts to be written offThe amount of the provision

AS students may be required to use the aged debtors analysis in the exam to calculate the amount of bad debts and the provision for doubtful debts.

Aged debtors analysis

Aged debtors schedule

Example:

Age of the debt Total debtors£

Up to 30 days 20,00031 to 60 days 18,00061 to 90 days 15,000Over 90 days 6,000

Aged debtors analysis

Policy:

Age of the debt Amount of provision (%)

Up to 30 days Nil31 to 60 days 561 to 90 days 10Over 90 days 20

Aged debtors analysis

Calculation:

Age of the debt Amount % Provision

Up to 30 days 20,000 0 0 31 to 60 days 18,000 5 90061 to 90 days 15,000 10 1,500Over 90 days 6,000 20 1,200 Total of provision 3,600

Tasks

Complete task sheet and OCR exam question.