1. Bad debts

2. 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.

3. 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

4. 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.

5. Accounting entries Debit - bad debts account
Credit - personal account of the debtor
John Green
Bal b\d 6, Bad debts 6,000
Bad debts account
John Green 6, Profit and loss a\c 6,000

6. 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:
Journal
Dr Cr
£ £
Bad debts ,000
John Davy ,000
Bank ,000
John Davy ,000

7. 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.

8. when creating a provision
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

9. when creating a provision
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.

10. 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 , Profit and loss 25,000
25, ,000
Bal b\d ,000

11. Provision for doubtful debts
Debtors must be shown in the balance sheet at the net figure.
Balance sheet extract
Current assets
Debtors ,000
Less provision for doubtful debts , ,000
The prudence concept has been applied and the debtors’ figure is not overstated.

12. The accounting entries to increase the provision
The accountant may decide that the provision is not enough and must be increased:
Debit profit and loss account
Credit 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:

13. Provision for doubtful debts account
Entries to increase the provision
Provision for doubtful debts account
Bal c\d 40,000 Bal b/d ,000
Profit and Loss 15,000
40, ,000
Bal b/d 40,000
Current assets
Debtors ,000
Provision for doubtful debts 40, ,000

14. 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:

15. Provision for doubtful debts account
Entries to reduce the provision
Provision for doubtful debts account
Profit and Loss 10,000 Bal b/d ,000
Bal c/d 30, , ,000
Bal b/d 30,000
Current assets
Debtors ,000
Provision for doubtful debts 30, ,000

16. 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.

17. Aged debtors schedule Example: Age of the debt Total debtors £
Up to 30 days ,000
31 to 60 days ,000
61 to 90 days ,000
Over 90 days ,000

18. Aged debtors analysis Policy: Age of the debt Amount of provision (%)
Up to 30 days Nil
31 to 60 days
61 to 90 days
Over 90 days

19. Aged debtors analysis Calculation: Age of the debt Amount % Provision
Up to 30 days 20,
31 to 60 days 18,
61 to 90 days 15, ,500
Over 90 days 6, ,200
Total of provision ,600

20. Tasks
Complete task sheet and OCR exam question.