You’ll remember that credit sales are those where an invoice is raised with an expectation of a cash payment at some point in the near future. The invoice should state the ‘credit terms’, saying that payment is expected within, maybe, 14 or 28 days.
Meanwhile, you as the bookkeeper will have recorded the sale in the records, with:
The Prudence concept now comes into play.
An asset should only be held at a given value if it is reasonable to expect that the business will (effectively) be able to make money from that asset. If any asset in the books is thought to be overstated, we make adjustments to bring the value back to something that we consider to be ‘realistic’.
In many cases, there are judgement calls to be made as my picture of ‘realistic’ might be different from yours. However, there are some circumstances where it’s quite clear cut.
Let’s go to the South side of Chicago, where Smoky Joe runs a café.
Most of his business involves card or contactless payments but, for a small number of regular customers, Smoky Joe runs a ‘tab’, allowing those customers to accumulate a bill which will be settled roughly every month.
One of these customers is Leroy Brown who eats regularly at Smoky Joe’s Café. He tends to settle his bill monthly but the tab for April and early May now stands at $450 and Leroy hasn’t visited the café for nearly six weeks.
It’s 30th June, Smoky Joe’s year end and his bookkeeper is going to prepare the accounts. However, there has recently been news that Leroy Brown was killed in a fight (the result of gambling and messing with the wife of another man).
It seems very unlikely, therefore, that the sum of $450 will be recovered so the value of debtors in the books must be reduced due to the application of prudence.
Smoky Joe, who has a very basic understanding of bookkeeping, has suggested reversing the sale, i.e:
While the credit entry does the correct thing, by removing that debt from the assets, there are two reasons why we don’t like debiting the sales:
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It would make it look as though the sale had never been made. That would, therefore, suggest that no meals had been prepared and no materials had been consumed. This is clearly incorrect, and the accounts should reflect that the ingredients were bought and used.
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‘Hiding’ the sale would also hide the fact that Smoky Joe had taken a risk in offering credit to Leroy and that this risk had, unfortunately, gone against him.
Therefore, we’ll leave the sales account untouched, but we create a “Bad Debts” expense account which will take the debit value of $450, with the credit going to Debtors.
This leaves the accounts showing:
Now it may happen that after Leroy’s funeral, one of his relatives finds an invoice or statement from Smoky Joe’s and, wanting to ‘square things up’, goes to the café with $450 and settles the debt. If that happens, we have to correct things by reversing that expense we created.
A simple journal would be:
The fact that it’s in a later year has to be accepted; last year’s P&L showed an expense but this year’s shows a ‘negative expense’ which in the long run has cancelled things out.
However, history would still show that Leroy Brown’s debtor account was brought to a value of zero through a bad debt. That’s probably not a legacy of which Leroy would be proud so what decency (not an accounting principle!) would suggest we do is:
We were able to identify Leroy Brown’s debt as being ‘bad’ due to the specific circumstances with the story of his death.
Smoky Joe has a café to run and can’t be expected to spend a lot of time going through newspapers and trawling the web for stories about his customers meeting untimely demises. However, we can convince him to be prudent and to accept that not all of his debtors might pay up everything in full.
Without identifying which debtors might go bad, we can create a ‘provision’ which has the effect of reducing the net value of debts receivable and recording an expense to reflect the risk taken when offering credit.
There are various ways to arrive at the value that will sit in that provision but the two main ones are:
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Specific Provision
Where the business might look at all debts that have been outstanding for more than, say, 90 days (in the aged debtor report) and agree that it is now doubtful whether they will pay.
The sum total of those debtors will be the provision.
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General Provision
Where the bookkeeper might look at previous years and establish that the cost of bad debts has been, say, 3% of total credit sales.
If, in the year under review, Credit sales have totalled $100,000, the provision in the accounts will have to be $3,000.
A bad debts provision account will sit in the balance sheet and will have a credit balance which offsets the debit balance in the debtors.
If there isn’t a brought forward provision, it must be set up using the journal:
- Debit Bad and Doubtful Debts expense (let’s say with $3,000)
- Credit Provision for Doubtful Debts (also with $3,000)
Following that, the annual review of doubtful debts will lead to an adjustment to the provision.
Next year, a review of aged debtors tells us that the provision for doubtful debts should be $3,750.
There’s already a balance in that account of $3,000, so our year-end adjusting journal will be:
- Credit the Provision for Doubtful Debts with $750, to bring the balance up to $3,750
- Debit Bad and Doubtful Debts expense with the increase of $750
In subsequent years, if the provision decreases, the double entry will be the other way round:
- Debit the Provision account to reduce the balance
- Credit Bad and Doubtful Debts, reducing the total expense.
We don’t have the issue of doubtful debts being unexpectedly settled at a later date as we did with Leroy Brown’s bad debt. This is because we haven’t been specific about labelling which customers fall into the category of ‘doubtful’.
So, there we have it. We’re being prudent by reviewing our debtors ledger and considering whether it shows a total balance that we can realistically expect to receive.
The P&L account each year will show an expense reflecting the cost of having given credit to customers who haven’t been reliable in paying.
The balance sheet will consist of two things:
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Debtors – an amount that our credit control can chase for payment. It is net of amounts ‘written off’ when we accept that we won’t ever recover amounts from some debtors.
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Provision for Doubtful Debts – an amount reducing the value of debtors to give a realistic figure. It leaves the debtors ‘whole’ so that we know how much to chase for from each customer.
