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

Also known as bad debt are those amounts owed by customers that are 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 income statement.
• The receivables ledger balance is reduced by the same amount.

Accounting entries

The journal entry to write-off an irrecoverable debt is given as:

Debit: Irrecoverable debt ledger account

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.

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 recognize an irrecoverable debt recovered is given as:

1. To reinstate the receivables with the amount recovered:

Debit: Receivables ledger account

Credit: Irrecoverable debt ledger account

2. To record the cash receipt;

Debit: Cash and bank ledger account

Credit: Receivables ledger account

Illustration: Walkthrough

Before the end of the year, Jentro Company Limited had a receivables ledger showing $13,760 due from debtors. The management of the company is certain that, based on experience with the customers, 20% of the amount due from the customers (i.e., $2,752) would not be recovered.

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 amount estimated to be unrecovered is first of all recorded as depicted below:

The journal entry is shown below.

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

1. 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 recognize the payment received.

See the journal entry below.

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

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.

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.

Definitions

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

Debit

Doubtful or (bad) debt 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 difference between the estimated allowance for doubtful debt and the presupposed actual debt that becomes irrecoverable is known as the movement in the allowance for the doubtful debt.

Definitions

Increase in allowance for doubtful debt

This is where the estimated allowance made for the doubtful debt is higher than the debt that eventually becomes irrecoverable.

Decrease in allowance for doubtful.

This is where the estimated allowance made for the doubtful debt is lower than the debt that eventually becomes irrecoverable.

How to compute the movement

In many questions:

• You’re given the allowance balance at the beginning of the period.
• You’re also given (or you calculate) the allowance needed at the end of the period.

The difference between the beginning and ending balances is the movement in the allowance for doubtful debt.

Sometimes, you’ll be given the movement and the beginning allowance, and you’ll need to determine the ending balance.

Exam Tip You may sometimes be given the information relevant to compute the beginning and or ending allowance for the doubtful debt.

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 amounted to USD 100,000 at year-end.
• Specific bad debts of USD3,000 were written off during the year.
• 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

Do you know the answer?

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

1. Increase in allowance for irrecoverable debt: Because the initial allowance was charged as an expense against the profit or loss account, an increase in the balance is an additional expense to be charged in the statement of profit or loss.
2. Decrease in allowance for irrecoverable debt: Because the initial allowance was charged as an expense against the profit or loss account, a decrease in the balance is recognised as income in the statement of profit or loss.

Statement of financial position

The ending balance of the allowance for irrecoverable debt is shown on the face of the statement of financial position. The balance is presented either as

1. Part of the current assets directly after the receivables or
2. Part of current liabilities

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 recognize 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

During the year, an amount of $1,800 was deemed irrecoverable, hence, needs to be written-off. At the end of the year, the receivables balance stood at $95,000. Management decided to make an allowance for 4% of the receivables net of any irrecoverable debt.

Required:

1. Prepare journal entries to recognize 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?

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

Do you know the answer?

6. Prepare the journal entries to recognise the movements

Do you know the answer?

Statement of financial position as at 31 December 2024 (Extract)

Current asset	$
Receivables	93,200
Allowance for doubtful debt	(3,728)

Sidenote

Keep in mind

The receivables shown are the balance per the question, adjusted for irrecoverable debt as per the journal entry.