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How to account for irrecoverable debts
Occasionally – but inevitably – credit sales will be made but not ultimately paid for. Income has still been generated that must now be offset with an expense. So how does that work?
Words Gill Myers, Evolve
Writing off a debt as irrecoverable is the end point of a process that ideally no organisation wants to reach. Unfortunately, it happens. So to understand how to account for sales that need to be written off, we need to start at the beginning.
Credit sales
When the credit period has passed, and the invoice is settled, the receipt is accounted for by:
Irrecoverable debts
There are a number of reasons why debts become irrecoverable. During the credit period there may be a dispute, the customer’s business may go into receivership or a contract may fall through. Regardless of the reason, it doesn’t change the fact that the sale was made in the first place. Therefore, the sales account is not adjusted when a debt is written off – rather, the value of the sale is offset with an expense, the double entry being:
How are irrecoverable debts different from doubtful receivables?
The difference is to do with the degree of certainty that a debt will not be paid. Organisations will have credit control processes in place to ensure that, as much as possible, monies from all sales made are received. However, sometimes that does not happen and when the non-receipt is definite, the debt should be written off. If not, both profit and current assets will be overstated.
If a customer goes out of business, leaving unpaid debts, it is easy to identify them as irrecoverable. However, while organisations often know from experience that some debts will become irrecoverable during the year, they are unlikely to be able to predict in advance which debts they will be. Making an allowance for doubtful receivables is therefore a way of acknowledging this situation.
The degree of certainty is not the only difference. Irrecoverable debts are written off completely, which reduces the receivables account balance and increases expenses. However, allowances for doubtful receivables are a contingency, made to comply with the accounting principle of prudence. Because debts might not, as opposed to definitely will not, get paid, the allowance is not posted to the receivables account. Instead, it is netted off against the receivables balance on the statement of finance position (SoFP) and an adjustment is shown on the statement of profit or loss (SoPL).
Allowances for doubtful receivables
Allowances for doubtful receivables can be calculated in two ways:
Year-end adjustments
The order of adjustments at year end is important when calculating the allowances:
1
Any irrecoverable debts must be written off and the receivables account rebalanced.
2
Specific allowances should be made and, if more than one, totalled.
3
Calculate the value of the remaining receivables by deducting the total value of specific allowances from the receivables account balance.
4
Calculate the general allowance from the value of remaining receivables.
5
Calculate the total allowance and make the year-end adjustments.
Accounting for an initial doubtful receivables allowance
When an organisation first sets up an allowance for doubtful receivables, the double entry is relatively straightforward:
The key point to understand is that because the allowance will reduce the value of receivables, it must have a credit balance. This is due to receivables being a current asset, meaning the account will have a debit balance. The adjustment account will be debited, and the value shown on the SoPL as an expense. This is very similar to accounting for an irrecoverable debt, other than the fact that the reduction in the value of receivables is only made on the SoFP and not in the actual account.
Accounting for an adjustment to an existing doubtful receivables allowance
Once an organisation has an allowance in place, it will need to be adjusted every year. That may involve increasing it, which will result in the same double entry posting as the set-up. Alternatively, it could need reducing. This would then require the allowance account to be debited, to bring the value of the allowance down. The double entry in the adjustment account would consequently be a credit. This would be included on the SoPL as ‘other income’ simply because it is the opposite of an expense, not because any money has been received.
KEY TAKEAWAYS
Irrecoverable debts and allowances for doubtful receivables are related but not the same. Adjustments are made for them for similar reasons: to be prudent and ensure that profit and non-current assets are not overstated in the financial statements. However, while the receivables balance is reduced by writing off irrecoverable debts in the accounts, it is only adjusted by the allowance for doubtful receivables on the SoFP. That means that the SoFP shows a net receivables figure. Finally, irrecoverable debts are an expense on the SoPL whereas the allowance for doubtful receivables adjustment account can be included as either an expense or income.
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