Bad debts
Bad debts
When 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 delivery
Trade references
Credit references
Bank references
Set a credit limit
Early settlement dates
How can a business
prevent bad debts for
existing customers?
Send regular statements to debtors
Follow up letter
Reminder letter with the threat of taking legal action
Using a third party such as a debt collector
Take 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 account
Credit - 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
Accounting entries
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:
Bad debts
John Davy
Bank
John Davy
Journal
Dr
£
3,000
Cr
£
3,000
2,000
2,000
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 consider
when creating a provision
Customer history
Type of customer
Size of the debt
Geographical position of the debtor
Interest rates
General economic factors
Expert knowledge of the business
sector
Factors to consider
when creating a provision
It 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
£500,000
5% Provision
£25,000
The accountants estimate that the asset of debtors is
£475,000.
The accounting entries
to create a provision for
doubtful debts
Debit - profit and loss account
Credit - provision for doubtful debts account
With the full amount of the provision
Total debtors £500,000
5% provision
Provision for doubtful debts account
Bal c\d
25,000
25,000
Profit and loss 25,000
25,000
Bal b\d
25,000
Provision for doubtful
debts
Debtors must be shown in the balance sheet at the
net figure.
Balance sheet extract
Current assets
Debtors
500,000
Less provision for doubtful debts 25,000
475,000
The prudence concept has been applied and the
debtors’ figure is not overstated.
The accounting entries to
increase the provision
The accountant may decide that the provision is not
enough and must be increased:
Debit Credit -
profit and loss account
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:
Entries to increase the
provision
Provision for doubtful debts account
Bal c\d
40,000
Bal b/d
Profit and Loss
40,000
Bal b/d
25,000
15,000
40,000
40,000
Current assets
Debtors
Provision for doubtful debts
800,000
40,000
760,000
Entries to reduce the
provision
The accountant may decide that the provision is too
high and will need to be reduced.
Debit - provision for doubtful debts account
Credit - profit and loss account
only 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
Bal c/d
10,000 Bal b/d
30,000
40,000
Bal b/d
40,000
40,000
30,000
Current assets
Debtors
Provision for doubtful debts
600,000
30,000
570,000
Aged debtors analysis
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 off
The 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 schedule
Example:
Age of the debt
Up to 30 days
31 to 60 days
61 to 90 days
Over 90 days
Total debtors
£
20,000
18,000
15,000
6,000
Aged debtors analysis
Policy:
Age of the debt
Up to 30 days
31 to 60 days
61 to 90 days
Over 90 days
Amount of provision (%)
Nil
5
10
20
Aged debtors analysis
Calculation:
Age of the debt
Amount
Up to 30 days
31 to 60 days
61 to 90 days
Over 90 days
20,000
18,000
15,000
6,000
Total of provision
%
0
5
10
20
Provision
0
900
1,500
1,200
3,600
Tasks
Complete task sheet and OCR exam
question.