Introduction to Introduction to AccountingAccounting

Unit 10 : Bad debts, provision for

doubtful debts, provision for discount on debtors

ObjectivesObjectives

After you have studied this chapter, you should:

Understand the difference between bad debts and provision for bad debts

How bad debts can be written offMake provision for bad and doubtful debtsCalculate and make provision for discount

on debtorsRecord accounting for bad debts’ recovery

In search for a profit In search for a profit some may become blind. some may become blind.

Businesses usually sell goods for cash or on credit.

When they sell goods on credit, their customers become their debtors.

Companies open personal accounts for those customers who owe them money for the products purchased.

as currentassets

They are reported in the Balance Sheet

Amounts owed by other companies or persons for goods, or services provided.

What are accounts What are accounts receivables?receivables?

.

Issues associated with Issues associated with Accounts ReceivablesAccounts ReceivablesGranting credits entails both

costs and benefits.When a company extends credit,

it experiences boost in sales.However, the cost of Accounts Receivables is the delay in receiving payment.

Will my debtors on Accounts Receivables pay me back or

not? When will they pay?

Bad DebtsBad Debts

Some debtors of the company may not be able to always honor their commitments.

The most significant cost of Accounts Receivables is uncollectible accounts or bad debts.

When the business cannot collect back the money from the debtors, the debt is said to be 'bad'. When the debt becomes bad, it has to be written off.

What makes companies not What makes companies not pay?pay?A) goods delivered were damaged;B) the customer claims that he has

not received all items on the invoice;C) the debtor’s business has failed

and the company has been closed;D) the debtor may be in short of

money;……..

Measurement of Measurement of uncollectible Accountsuncollectible Accounts

ABC company has credit sales of $100,000 during 2006.

Collections during 2006 were $60,000.On December 31, 2006 AR are

$40,000.During 2006 there were not bad debts. However, 40% of the year’s sale are

still unpaid, and some may never be paid.

Company’s challengesCompany’s challengesHow should ABC account for their

Accounts Receivables?Will it collect all Accounts

Receivables?If they think that some of the

accounts will not be collected, which accounts are they?

Determining the true value Determining the true value of Accounts Receivablesof Accounts ReceivablesTwo methods are used in

accounting for uncollectible accounts:

1) the direct write-off method (specific write-off method);

2) the allowance method;

Direct write-off methodDirect write-off methodUsed by companies that rarely

experience problems with collecting debts;

If uncollectibles are small and infrequent, this practice does not misstate the economic situation in a material way;

Direct write-off method in Direct write-off method in practicepracticeWith our previous example, let’s

assume that only two customers were not able to pay (Mr. James Bond and Mr. Bill Brown).

The company uses the direct write-off method for uncollectible debts on AR.

So, they write-off $2,000 in 2007. (the year after)

Direct write-off method

Assets Liabilities Capital

2006 Sales

+$100,000(increase AR)

+$100,000(increase sales)

2007 Write-off

-$2,000(decrease AR)

-$2,000(increase Bad Debts expense)

Accounting treatment of Bad Accounting treatment of Bad DebtsDebts

When a bad debt is to be written off, the entry is:a) Dr Bad Debt $2,000

Cr Debtor’s account$2,000

Income statement (extract) for the ending 31 December 2008

Gross Profit xxxLess Expenses:

Bad debts ($2,000)

Direct write-off methodDirect write-off methodCBB company writes off M.E.

Doran’s $200 balance as uncollectible.

Dr. Bad debts expense200◦Cr AR – M.E. Doran 200

AR are recorded at its gross amount.

What are the drawbacks of What are the drawbacks of the Direct-off method? the Direct-off method? It fails to apply the matching

principle of accrual accounting;Matching requires recognition of

the bad debts expense at the same time as the related revenue;

So, when using this method, we overstate our income of 2006 year;

We understate our income of 2007 year;

Matching principleMatching principleOur Expenses must follow our Revenues.

Our efforts should be matched with our accomplishments.

Direct write-off method: Matching

violated

Matching applied

correctlySales Revenue

2006$100,000

20070

2006$100,000

20070

Bad debts expense

0 $2,000 $2,000 0

Allowance methodAllowance methodAs Direct-off method violates the

matching principle and bad debts are neither small nor similar from year to year, accountants use the method of allowances.

DoubtfulDoubtful Debts Debts Financial Statements - Trading

a/c, P/L a/c and Balance Sheet, are prepared at the end of the year to ascertain the Net profit and the value of the assets and liabilities at the end of the year.

As companies do not know which of the debtors will not pay, they try to estimate the amount of future non payments in advance.

So, these predicted debts are called as doubtful debts.

Businesses are to make provisions (also named as allowances) for doubtful debts.

Specific features of the Specific features of the allowance methodallowance methodIt is an estimate of the accounts

that will become uncollectible;It is a contra account, which

contains the estimated uncollectible amount;

This amount is deducted from the total accounts receivables;

The other names of this The other names of this method are as follows:method are as follows:Allowance for doubtful accounts

Allowance for bad debtsReserve for doubtful accounts

Benefits of the allowance Benefits of the allowance methodmethod

We recognize bad debts in general during the proper period, before we identify specific uncollectible accounts from specific individuals in the following year.

Suppose, ABC company from its past experience knows that it will not collect 2% of sales.

$100,000x2%=$2000;Now is uses Allowance method;

Allowance method

Assets = L-ty Capital

2006 Sales +100,000(increase AR)

+100,000(increase sales)

2006 Allowance

-$2,000(Increase allowance for uncollectible accounts)

-2,000(increase Bad debts expense)

2007 Write-off

+$2,000(Decrease in allowances for uncollectible accounts)

No effect

-$2,000 (Decrease Accounts Receivables)

Accounting Entries for Accounting Entries for Doubtful DebtsDoubtful Debts

1) 2006 Dr AR $100,000Cr Sales $100,000

2) 2006 Dr Bad debts expense $2,000Cr Provision for doubtful debts$2,000

3) 2007 Dr Provision for doubtful debts $2,000 Cr. Account Receivable $2,000

Balance sheet as at Balance sheet as at December, 31,2006 (extract)December, 31,2006 (extract)

Accounts Receivables$40,000

Less: Provision for doubtful debts $2,000Net Accounts Receivable $38,000

Methods of Estimating Bad Methods of Estimating Bad DebtsDebts

Percentage of Credit Sales Method

(it provides better matching of expenses with revenues – an income statement viewpoint)

Aging of Accounts Receivable Method

(it produces the better estimate of cash realizable value – a balance sheet viewpoint)

Methods of Estimating Methods of Estimating Bad DebtsBad Debts

Applying the allowance method using a percentage of Accounts Receivables.Companies use their historical experience but estimates are based on year-to-year uncollectible debts.

AR at end of Year

Bad debts deemed uncollectible and written off in subsequent year

2001 100,000 3,500

2002 80,000 2,450

2003 90,000 2,550

2004 110,000 4,100

2005 120,000 5,600

2006 112,000 2,200

Six-year total

612,000======

20,400=====

Average (divide by 6)

102,000======

3,400=====

Average percentage not collected = 3,400/102,000=3,33%

Aging of Accounts Receivable Method

We age each customer’s account by separating the total amount owed by each customer into aging categories.

These aging categories are based on the number of days that have passed since uncollected amounts were first recorded in the account.

Applying the allowance Applying the allowance method using the method using the percentage of salespercentage of salesWe express the amount of bad

debts as a percentage of total sales.

This method relies on historical relationships between credit sales and uncollectible debts.

Next, based on past experience, the business estimates the percentage of uncollectible accounts in each time category.

Then multiply these percentages by the appropriate column totals.

The column totals are then added to arrive at the total estimate of uncollectible accounts

Record the year-end adjusting entry

customer Total Number of days unpaid

0-30 32-60 61-90 over 91

ABS company 700

KG company 1,900 1900

Delta Company 2,200 2,200

TB company 6,000 6,000

Zeta company 1,800 1800

KLM company 600 600

Total 13,200

% Uncollectible 2% 4% 8% 10%

Estimated uncollectible amount

938 38 124 176 600

Remember,Remember,Whatever method the company

uses to estimate the value of bad debts, the recording is the same:

Dr. Provision for doubtful debts

Cr. Accounts Receivable (individual debtor’s account) (both accounts are decreased)

Bad debts recoveriesBad debts recoveriesBad debts are recovered, when a

customer pays an account that a company has previously written off.

Recording bad debt Recording bad debt recoveryrecovery1) Dr. AR $600 Cr. Sales $600 (we record the sales of $600 to

Monterro, our specific customer )2) Feb, 2002 Dr. Allowance for doubtful debts $600

Cr. Accounts Receivable$600

(to write-off uncollectible account of Monterro)

3) Oct. 2002Dr. Accounts receivable $600 Cr. Bad debt recovery account$600

(to reverse February 2002 write-off of account of Monterro)

4) Dr. Cash $600Cr. Account Receivable $600

(to record the collection on account)

Accounting Entries for Recovery of Bad Accounting Entries for Recovery of Bad DebtsDebts

Mr. A, whose account was written off previously pays his debt of $2,000.

1) Cash a/c Dr 2,000 Mr. A's a/c

2,000 2) Mr. A's a/c Dr 2,000

Bad debt recovery a/c2,000

3) Bad debt recovery a/c 2,000 P/L a/c

2,000

At the end of the financial year, the credit balance in the bad debts recovered account is transferred either to the bad debts account or direct to the credit side of the profit and loss account.

Increase or Decrease in Provision for Increase or Decrease in Provision for Doubtful DebtsDoubtful Debts

Year 2006 provision for doubtful debts is $200

Year 2007 provision for doubtful debts is $500

Year 2008 provision for doubtful debts is $400

Solution:Solution: 2006 Dr. P/L a/c 200 Provision for doubtful debts 200 2007 (There is an increase in provision) Dr. P/L a/c 300 Provision for doubtful debts 300 2008 (There is a decrease in provision) Provision for doubtful debts 100 Cr. P/L a/c 100 After the initial provision is made, any increase or

decrease is made to this figure year after year, depending on the amount required at that year-end.

8-48

Thank you Thank you

The End