Irrecoverable and doubtful debts

It’s normal for some customers not to pay what they owe. In other cases, you may not be sure whether a customer will be able to pay. This chapter explains how both situations affect the receivables ledger account.

Learning objective

By the end of this lesson, you should be able to:

• Prepare manual journal entries to write off an irrecoverable debt.
• Prepare manual journal entries to recognise an irrecoverable debt that is subsequently recovered
• Demonstrate the impact of irrecoverable debts on the statement of profit or loss and on the statement of financial position.
• Prepare manual journal entries to create and adjust an allowance for irrecoverable debts.
• Illustrate how allowance movements appear in profit or loss and how closing balances are presented in the statement of financial position.

Irrecoverable debt

Definitions

Irrecoverable debt

An irrecoverable (bad) debt is an amount owed by a customer that is deemed uncollectible after all reasonable collection efforts.

Irrecoverable debts usually arise because a customer becomes bankrupt, closes their business, or is otherwise unable to pay.

Once a debt is considered irrecoverable, it can’t continue to be recognised in the accounting records. It’s treated as a loss:

• It’s written off as an expense in the statement of profit or loss.
• The receivables ledger balance is reduced by the same amount.

Accounting entries: The journal entry to write-off an irrecoverable debt is:

Debit: Irrecoverable debts expense

Credit: Receivables ledger account

Recovery of a written-off irrecoverable debt

Sometimes, after a company writes off a debt as uncollectible, the customer later pays. When a previously written-off irrecoverable debt is recovered, it creates a cash inflow for the company.

The amount recovered is brought back into the accounts indirectly as income.

Two-step approach

To record the recovery, you do two steps:

• First, reverse the earlier write-off (so the receivable is reinstated).
• Then, record the cash received (which reduces receivables again).

Accounting entries: The journal entry to recognise an irrecoverable debt recovered is:

1. To reinstate the receivables with the amount recovered:

Debit: Receivables ledger account

Credit: Irrecoverable debts expense

2. To record the cash receipt:

Debit: Cash and bank ledger account

Credit: Receivables ledger account

One-step approach

This approach stems from the journal entries in the two-step approach above. The debit to the receivables ledger account upon the reinstatement is cancelled out by the credit to the same account upon receipt of the balance. That means, the simple and straightforward journal will be:

Accounting entries:

Debit: Cash and bank ledger account

Credit: Irrecoverable debts expense

Illustration: walkthrough

Before the end of the year, Jentro Company Limited had a receivables ledger showing $13,760 due from customers. This balance includes $2,752 owed by a customer who has been declared bankrupt, so management decides to write this debt off as irrecoverable.

At the end of the year, a customer whose debt was part of the earlier written-off debt paid his balance of $1,000.

Required: prepare manual journal entries to recognise the irrecoverable debt.

Suggested answer:

1. The identified irrecoverable debt is first written off as shown below:

The journal entry is shown below.

	Debit	Credit
Irrecoverable debts expense	$2,752
Receivables ledger account		$2,752
Being write-off of irrecoverable debt

2. Upon recovery of the $1,000 from the customer whose balance was included in the write-off above, the entry is reversed as if the amount was not earlier written off, and then the correct entry is passed to recognise the payment received.

See the journal entry below.

	Debit	Credit
Receivables ledger account	$1,000
Irrecoverable debts expense		$1,000
Being reinstatement of irrecoverable debt written-off
Cash and bank ledger account	1,000
Receivables ledger account		1,000
Being payment received from a customer

As explained under the one-step approach above, the receivables ledger cancels itself out, leaving only cash and bank and irrecoverable debts expense:

	Debit	Credit
Cash and bank ledger account	1,000
Irrecoverable debts expense		1,000
Being recovery of written-off debt received

Allowance for doubtful debt

Definitions

Doubtful debt

It is the portion of receivables that may become uncollectible due to uncertainty about the customer’s ability or willingness to pay.

The allowance for doubtful debts is also known as the allowance for irrecoverable debts (the term used in the ACCA study guide). This chapter uses “allowance for doubtful debt” throughout.

It helps to separate these two ideas:

• With doubtful debts, you’re uncertain whether the customer will pay.
• With irrecoverable debts, you’re certain the customer won’t pay.

When there’s doubt about recoverability, the business sets aside an amount to cover possible future losses. This applies the prudence concept.

So, unlike an irrecoverable debt (which is written off immediately), a provision or allowance is created for a doubtful debt.

Accounting entries: Upon creating allowance for doubtful debt for the first time, the whole amount is charged as an expense in the statement of profit or loss. The journal entry follows as:

Debit: Irrecoverable debts expense

Credit: Allowance for doubtful debt

Movement in allowance for doubtful debt

Once an allowance is created, the estimate may change from one period to the next. The actual debts that become irrecoverable may also differ from what was estimated.

The movement in the allowance for doubtful debt is the difference between the allowance required at the end of the period and the allowance brought forward at the start of the period.

Definitions

Increase in allowance for doubtful debt

This is where the closing allowance required is higher than the opening allowance, and the increase is charged as an expense in the statement of profit or loss.

Decrease in allowance for doubtful debt

This is where the closing allowance required is lower than the opening allowance, and the decrease is credited (recognised as income) in the statement of profit or loss.

Sometimes you’ll be given the movement and the opening allowance instead, and you’ll need to work out the closing balance.

Exam tip: Always write off specific irrecoverable debts before calculating the allowance for doubtful debts, so the percentage is applied to receivables net of any write-off. Expected credit loss models under IFRS 9 aren’t examinable at this level; allowances here are calculated using simple percentages, as shown in the illustrations below.

Illustration

On 1 January 2024, Anthem PLC had an allowance for doubtful debts of USD 4,000. During the year ended 31 December 2024, the following occurred:

• Receivables of USD 100,000 at year-end include specific debts of USD 3,000 that are to be written off as irrecoverable.
• Management decided that at 31 December 2024, an allowance equal to 5% of receivables should be maintained.

Required:
(a) Compute the allowance for doubtful debts as at 31 December 2024.
(b) Determine the movement in the allowance and show the adjustment in the statement of profit or loss (SPL).

Suggested solution:

Step 1: compute year-end allowance or provision

Do you know the answer?

Step 2: movement in allowance

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Accounting treatment

The allowance for doubtful debt affects both the statement of financial position and the statement of profit or loss. The key is to track how the allowance changes during the period and what the closing balance is.

Statement of profit or loss

Only the movement in the allowance goes to profit or loss, as an expense or as income, as set out above. The closing balance never does.

Statement of financial position

The ending balance of the allowance for doubtful debt is shown on the face of the statement of financial position. The closing allowance is deducted from trade receivables within current assets, so receivables are shown net of the allowance. It is never shown as a liability.

Illustration one:

On 1st January, 2024, Jentro Company Limited had a receivables balance of $80,000 and allowance for doubtful debts of $2,400. As at 31st December, 2024, receivables balance stood at $95,000 while allowance for doubtful debts increased to $4,000. Required:

1. Prepare journal entries to recognise the movements in the allowance for doubtful debt
2. Prepare an extract of the statement of financial position as at December 31, 2024.

Suggested solution:

1. Preparation of manual journal entries

Do you know the answer?

2. Statement of financial position as at 31 December 2024 (extract)

Do you know the answer?

Illustration two:

Jentro Company Limited had the following balances at January 1, 2024:

• Receivables: $80,000
• Allowance for doubtful debts: $4,400

At the end of the year, the receivables balance stood at $95,000, before writing off an irrecoverable debt of $1,800. Management decided to make an allowance for 4% of the receivables net of any irrecoverable debt.

Required:

1. Prepare journal entries to recognise the movements in the allowance for doubtful debt
2. Prepare an extract of the statement of financial position as at December 31, 2024.

Suggested solution:

1. First of all, recognise the effect of the irrecoverable debt on the receivables balance.

Do you know the answer?

2. Determine the end of year allowance for doubtful debt.

Do you know the answer?

3. Determine the movements in the allowance for doubtful debt balance.

Do you know the answer?

4. Prepare the journal entries to recognise the movements

Do you know the answer?

5. Prepare the statement of financial position extract.

Do you know the answer?

Profit or loss shows an irrecoverable debts expense of $1,128 ($1,800 written off less the $672 decrease in the allowance).

Refer to ACCA technical write-up on sales and trade receivables written by a member of the examination team.