Chapter 25 Bad debts, allowances for doubtful debts, and provisions for discounts on accounts receivable

Learning objectives After you have studied this chapter, you should be able to: Explain and show how bad debts are written-off Explain why allowances for doubtful debts are made Make the necessary entries to record an allowance for doubtful debts in the books

Learning objectives (Continued) Calculate and make provisions for discounts on accounts receivable Make all the entries in the income statement and statement of financial position for bad debts, allowances for doubtful debts and provisions for cash discount

Bad debts Many businesses sell on credit and there is therefore a risk that some customers will not pay for their goods and become a bad debt. When a debt is considered bad, the asset shown in the debtor’s account is worthless and so eliminated. Bad debts are considered a business expense and are charged to the income statement as an expense.

Recording a bad debt Credit the debtor’s account to remove the debt. Debit the bad debt account to increase the expense.

Recording a bad debt (Continued)

Allowance for doubtful debts It is likely that some debts held by the business will prove to be bad debts. The prudence concept says that this possibility needs to be provided for in the current period. Therefore an allowance needs to be made in the current period for debts that might be bad by: debiting the p+l account with the allowance Crediting the allowance for doubtful debts account.

Creating an allowance for doubtful debts

Increasing the allowance To increase the allowance: Debit the profit and loss account with the increase in the allowance. Credit the allowance for doubtful debts account.

Increasing the allowance (Continued)

Reducing the allowance To reduce the allowance: Debit the allowance for doubtful debts account. Credit the profit and loss account.

Reducing the allowance (Continued)

Provisions for cash discounts on accounts receivable Some businesses create provisions for cash discounts to be allowed on the accounts receivable outstanding at year end. It is argued that the cost of discounts should be charged in the period when the sales were made. The procedure used is similar to that used for the allowance for doubtful debts.

How to record provisions for cash discounts

Learning outcomes You should have now learnt: That debts we are unable to collect are called bad debts That bad debts are credited to the customer’s account (to cancel them) and debited to a bad debts account

Learning outcomes (Continued) That allowances for doubtful debts are needed, otherwise the value of the accounts receivable in the statement of financial position will show too high a value, and could mislead anyone looking at the statement of financial position. Also, making a provision of this type allows for more accurate calculation of profits and losses

Learning outcomes (Continued) That the allowance for doubtful debts is calculated after bad debts have been deducted from the debtor balances That the amount of the allowance for doubtful debts is based on the best estimate that can be made taking all the facts into account That an increase in the allowance for doubtful debts will create a debit entry in the profit and loss account

Learning outcomes (Continued) That a reduction in the allowance for doubtful debts will create a credit entry in the profit and loss account That the allowance for doubtful debts is shown as a deduction from accounts receivable in the statement of financial position That provisions for cash discounts are made in the same way as provisions for doubtful debts

Learning outcomes (Continued) 10. How to record bad debts, allowances for doubtful debts and provisions for cash discounts in the accounting books and in the income statement and statement of financial position