Chapter 5 - Bad Debts, Provision for Doubtful Debts and Cash Discounts PDF

11/30/2023 1 5 Bad Debts, Allowance for Doubtful Debts, and Allowance for Discounts 2 1  11/30/2023 Learning Out...

11/30/2023 1 5 Bad Debts, Allowance for Doubtful Debts, and Allowance for Discounts 2 1  11/30/2023 Learning Outcomes After studying this chapter, you should be able to: ❑ Explain what is meant by a bad debt ❑ Explain why allowance for doubtful debts is created ❑ Explain why allowance for discounts allowable is created ❑ Record a bad debt, allowance for doubtful debts and allowance for discounts allowable in the journals and ledgers Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–3 3 10.0 Introduction Adjusting entries should be made before the preparation of final accounts to conform to the conventions of accounting. ❑ In your daily life, have you ever experienced lending money to your friends and that person did not pay you back? ❑ In accounting, this is called bad debt. Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–4 4 2  11/30/2023 10.1 Bad Debts ❑ A bad debt is a debt by a customer that is almost certain to be uncollectible. ❑ Whenever a bad debt occurs, the specific customer’s balance must be written off and the account closed. ❑ There are many reasons why a bad debt can occur: – The debtor may have passed away. – The debtor may have become bankrupt. – The debtor may have disappeared and cannot be contacted. – The debtor simply cannot afford to pay the debt. Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–5 5 10.1 Bad Debts (cont.) ❑ The bad debt account must be charged as an expense in the Statement of Profit or Loss and Other Comprehensive Income. ❑ The double entries are as follows: Dr. Bad debts expense XX Cr. Account Receivable – customer XX (Bad debt direct write-off – customer ABC) Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–6 6 3  11/30/2023 10.2 Allowance for Doubtful Debts - Types ❑ There are two types of allowance for doubtful debts: – Specific allowance Created for specific receivables whereby it is possible that the amount can no longer be recovered in full. The amount is not written off in full as in the case of bad debts. However, a specific allowance is created based on an estimate (say 20% of the balance). – General allowance Although the business cannot identify any specific customer that will not settle their debts in the future, based on past experiences, it is estimated that a certain percentage will not be recoverable due to unforeseen circumstances. Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–7 7 10.2 Allowance for Doubtful Debts – Methods to calculate Percentage of Sales Method ❑ The sales method applies a flat percentage to the total dollar amount of sales for the period. Accounts Receivable Aging Method ❑ All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group. The aggregate of all group results is the estimated uncollectible amount. Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–8 8 4  11/30/2023 Example - Percentage of Sales Method ❑ Based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense. ❑ If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400. Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–9 9 Cont’. ❑ Based on previous experience, company X may expect that 3% of net sales are not collectible. - Gross sales 120,000 - Net sales 100,000 - Expenses 45,000 - Cost of goods sold 57,000 Calculate the allowance for doubtful debts based on the percentage of net sales method. Answer: 3% x 100,000 = 3,000 Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–10 10 5  11/30/2023 Example - Accounts Receivable Aging Method ❑ A company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and 4% of those accounts receivable at least 30 days old will be uncollectible. ❑ Therefore, the company will report an allowance of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 - $1,900) will be the adjusting entry amount. Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–11 11 Cont’. Period 1 < 30 days 30 day and more AR balance 70,000 30,000 Estimation % 1% 4% Allowance for 1% x 70,000 = 700 4% x 30,000 = 1,900 doubtful debts 1,200 Period 2 < 30 days 30 day and more AR balance 85,000 40,000 Estimation % 1% 4% Allowance for 1% x 85,000 = 850 4% x 40,000 = 2,450 (previously doubtful debts 1,600 in period we already have 1,900. Thus, to make it 2,450, we just need Fundamentals of Financial Accounting (SECOND EDITION) to topAll upRights 550)Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–12 12 6  11/30/2023 10.2 Allowance for Doubtful Debts (cont.) ❑ Allowance for doubtful debts is estimated at the end of the accounting period. It is based on experience and knowledge of the customers database and economic conditions. ❑ An allowance for doubtful debts is also an expense and should be charged to the Statement of Profit or Loss and Other Comprehensive Income as one of the expenses. Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–13 13 The Journal Entry ❑ To create allowance for doubtful debts: Dr. Bad debts expense xx Cr. Allowance for doubtful debts xx ❑ To write-off bad debts using the allowance for doubtful debts: Dr. Allowance for doubtful debts xx Cr. Account Receivable – Customer ABC xx ❑ To direct write-off the bad debts (if no provision made earlier): Dr. Bad debts expense xx Cr. Account Receivable – Customer ABC xx Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–14 14 7  11/30/2023 Example – journal entry ❑ Based on previous experience, Company ABC may expect that 3% of net sales are not collectible. The total net sales for the period is $100,000. Create a journal entry for the allowance of doubtful debts. The journal entry Dr. Bad debts expense 3,000 Cr. Allowance for doubtful debts 3,000 (Recording an allowance for doubtful debts) Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–15 15 Example – journal entry ❑ Company ABC identified one customer (customer A), went bankrupt. The customer has outstanding amount in Account Receivable amounting to RM1,500. Prepare a journal entry to write-off the Account Receivable – customer A. The journal entry Dr. Allowance for doubtful debts 1,500 Cr. Account Receivable – Customer A 1,500 (Writing-off Account Receivable for customer A - bankrupt) Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–16 16 8  11/30/2023 Example – journal entry ❑ In Company XYZ, there is a big customer (customer G) went bankrupt. The company never provide any allowance for doubtful debts before. Customer G has outstanding amount in Account Receivable amounting to RM5,500. Prepare a journal entry to direct write-off the Account Receivable – customer G. The journal entry Dr. Bad debts expense 5,500 Cr. Account Receivable – Customer G 5,500 (Direct write-off Account Receivable for customer G - bankrupt) Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–17 17 10.3 Bad Debts Recovered ❑ Bad debts written off in previous years may be recovered in later years. This could be due to better trading results in the future etc. ❑ Therefore, bad debts recovered are payments received in respect of the debts after they have been written off. ❑ A recovered bad debt is a form of profit and must be transferred to the Statement of Profit or Loss and Other Comprehensive Income as a other income. Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–18 18 9  11/30/2023 10.3 Bad Debts Recovered (cont.) ❑ The steps to record the bad debts recovered are as follows: Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–19 19 Example – Bad debts recovered ❑ Company XYZ – customer G, who had been write-off from the company’s book come back to pay his outstanding amount RM5,500. Prepare a journal entry to re-open the account for bad debts recovered. The journal entry Dr. Account Receivable – Customer G 5,500 Cr. Bad Debts Recovered 5,500 (Re-open customer G account receivable to record bad debts recovered ) Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–20 20 10  11/30/2023 Example – Bad debts recovered The journal entry (cont’.) Dr. Cash 5,500 Cr. Account Receivable – Customer G 5,500 (Cash received from customer G for bad debts recovered) Dr. Bad Debts Recovered 5,500 Cr. Other Income 5,500 (Recognise other income for bad debts recovered from customer G) Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–21 21 10.4 Allowance for Discounts ❑ There are two types of discounts: – Trade discounts (received from a seller at the time of buying the goods) – Cash discounts (received or paid for prompt payment) ❑ There are two types of allowance for discounts: – Allowance for discounts allowable (business gives to debtors) – Allowance for discounts receivable (business receives from creditors) Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–22 22 11  11/30/2023 10.4.1 Allowance for Discounts Allowable ❑ Some businesses create allowance for discounts to be allowed on the accounts receivable outstanding at the statement of financial position date. ❑ By allowing for this, a better estimate of collectible debts can be made, owing to cash discounts which will be given to debtors if they pay within a given time. ❑ The way to record the allowance for discounts allowable is as follows: Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–23 23 10.4.1 Allowance for Discounts Allowable (cont.) – When the allowance is created for the first time: – Increasing the allowance for discounts on debtors that has been created already: – Reducing the allowance for discounts on debtors that has been created already: Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–24 24 12  11/30/2023 10.4.2 Allowance for Discounts Receivable ❑ Some businesses which normally take advantage of such discounts may decide to take credit of it in the Statement of Profit or Loss and Other Comprehensive Income. ❑ In the Statement of Financial Position, the total accounts payable amount would be reduced by the allowance. ❑ The double-entry treatments would follow the same rule as the allowance for the discounts allowable, except that it would be the other way around and based on accounts payable. Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–25 25 - THE END - Fundamentals of Financial Accounting (SECOND EDITION) All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2018 1–26 26 13