Each month, Peter Stewart, ICB’s Director of Learning, shares expert insights in our Bookkeeping in Practice series. In this edition, Peter unpacks the accounting treatment of bad and doubtful debts — a key topic for students preparing for their Level 3 Certificate in Bookkeeping and Accounting.
This month’s article is aimed at students who are working towards the level 3 Certificate in Bookkeeping and Accounting; mainly those who are studying for M4, but it also applies for M5, M6, M7 and M8.
In an earlier article, I wrote about the PRUDENCE concept in accounting and how that tells us that we should be sure that assets are not stated at too high a value as it might mislead readers as to the overall value of the business.
In a later article, I explained how the value of a business rarely comes from what is seen in the balance sheet but that doesn’t mean that many people will look at a balance sheet, see a debtors value of, say, £30,000, and expect that it means the business is due to receive cash of £30,000 from customers in the coming months. It’s entirely reasonable!
The point of the prudence concept is to double check that there is a good chance of receiving that £30,000 in full. If not for external readers of the accounts, it will help with planning within the business as it can produce a reliable cash forecast if confident of that income from customers.
So, before signing off on a debtors value of £30,000 in the balance sheet, the business’s management should review the list of debtor balances and question the likelihood of receiving cash from all debtors in full.
This is the value of producing an aged debtors report. If we made sales with invoices asking for payment within 30 days, the “0 – 30 days” column of the aged debtors report should give us little cause for concern.
However, when we turn our attention to the “90 days and more” column, we should scrutinise that in detail, attempting to make contact with all customers and establish how and when they will pay.
There are, of course, other sources of information to help us. It could be news articles; it could be on the business grapevine but if we hear stories of a customer’s staff not being paid their wages or see an announcement of a customer going into administration, prudence should point us towards expecting that the debt won’t be paid. This is likely to be a BAD DEBT.
Treatment of a bad debt
When we’ve identified that a debt is bad, we must reduce the value of debtors in the balance sheet. Doing that is easy: we created the asset by debiting the Debtors account, so we can reduce it by crediting the same account. Job done!
But all entries need a mirroring “double” entry. In this case we can’t reverse the other side of the original entry (which was Sales). The reason is that the Sale has not become “unmade”; the goods have been consumed by the customer or the service has been completed.
Instead, the business must recognise that it offered credit terms to someone who, with hindsight, it shouldn’t have. This is a business expense reflecting either bad luck or poor judgement.
Therefore, the debit side of the journal is to a Bad Debts Expense account.
Example
In the total debtors of £30,000, we discover that there is a debt for £2,000 outstanding from a customer who we’ve recently learnt has gone into administration.
Although administration leaves a glimmer of light that the customer’s business will survive, we’ll be prudent and write that amount off.
The journal entry is then:
Debit Bad Debts Expense £2,000
Credit Debtors £2,000
The debtor balance is now £28,000 and the profit has been reduced (through expenses) by the same amount.
The customer’s account now shows a zero balance.
Doubtful Debts
In some cases, we will have a suspicion that debts are not going to be settled. It may be that we’ve phoned and emailed the customer who’s replied with all the “right” responses, but money is not forthcoming. There may be no other signals or stories to suggest the customer can’t or won’t pay.
We don’t want to write off the customer’s balance from the debtor account as we still want to chase in the hope of payment but we’re doubtful whether we’ll receive the full amount.
The approach here is to leave the debtors account as it stands (i.e. now at £28,000) but to create a “provision” in the accounts which has the prudent effect of lowering the amount we’re showing as expected to be received.
Example
The aged debtor report shows another customer with whom we’re still in regular communication. However, an invoice of £1,000 has been outstanding for four months and the customer has been disputing whether the service was provided. We know it was but, to be on the safe side, we’ll call it a doubtful debt.
This time, to reduce the value of debtors, the credit entry is to create a Provision for Doubtful Debts accounts which will sit within the balance sheet as a credit. In summary, the balance sheet will have:
Debtors £28,000
Provision for Doubtful Debts £1,000
They net off to give an asset value of £27,000 but, importantly, the debt is still there in our records, so that we know to continue pursuing payment.
The other side of the journal does the same as writing off a bad debt; it creates an expense reflecting the cost to us of doing business on credit with unfortunate outcomes.
In summary, the journal will be:
Debit Doubtful Debt Expense £1,000
Credit Provision for Doubtful Debts £1,000
General provision for doubtful debts
It is possible that a business doesn’t identify specific customers about whom it has some doubt over, but knows from experience that, say, 2% of debts remain unpaid.
In this case prudence says we must reduce the debtors balance by 2%. Since we don’t have a specific debt to write off, we do exactly as above: create a provision with the same journal entries.
Changes to a provision
At the end of each accounting period, the business will review the provision for doubtful debts to consider whether it is sufficient. Having reviewed specific and general provisions, the journal that is needed is only to account for the difference between the balance we’ve got and the balance we want.
Example
At the end of the next period, we assess the aged debtors report and decide we need the doubtful debt provision to be £1,250. In other words, we are currently under-providing by £250. So we will simply “provide” a further £250.
The journal will, therefore, be:
Debit Doubtful Debt Expense £250
Credit Provision for Doubtful Debts £250
The expense for the period is £250 but the provision (the amount by which the net debtors balance is reduced) is £1,250.
If this isn’t too confusing, it’s similar to the provision for depreciation that we apply to fixed assets. Each year there’s an expense and at the end of each year, the value of the asset becomes lower. The difference is that a provision for doubtful debts can go up (as per the example) but can also go down, in which case the bad debt expense is reduced by the change in the provision.
Conclusion
I hope that this has helped you to understand why the accounting for bad and doubtful debts is what it is. If you are studying towards your level 3 exams, the best thing you can do now is to get your hands on some scenario exercises that ask you to make the accounting adjustments yourself.
Good luck with your studies and with your exams!
