Chapter 8: Irrecoverable Debts & Allowance for Receivables PDF

## Chapter 8: Irrecoverable Debts and the Allowance for Receivables ### Introduction * Learning Outcomes * Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in line with relevant accounting standards. * Identify the components of a...

## Chapter 8: Irrecoverable Debts and the Allowance for Receivables ### Introduction * Learning Outcomes * Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in line with relevant accounting standards. * Identify the components of a set of financial statements and their purpose and relationships. * Prepare a statement of financial position, statement of profit or loss, statement of changes in equity and statement of cash flows. * Syllabus Links * Chapter material will be developed further in the Accounting module, and then in Professional Level Financial Accounting and Reporting * Examination Context * Questions in this chapter will be set as multiple choice, multi-part multiple choice or multiple-response questions, involving calculations. * Expect to be tested on preparing a journal. ### Irrecoverable Debts #### Section Overview * **Writing off an Irrecoverable Debt:** * Debit: Irrecoverable debts expense * Credit: Trade receivables * **Accounting for the receipt of cash in respect of a debt previously written off:** * Debit: Cash at bank * Credit: Irrecoverable debts expense * **Irrecoverable Debt Definition:** A debt not expected to be paid. * **Writing off:** Charging the cost of the debt against the profit for the period. #### Writing Off Irrecoverable Debts * When a business decides a debt will not be paid, the whole amount of the receivable is written off as an expense in the statement of profit or loss. * Debit: Irrecoverable debts expense * Credit: Trade receivables * **Example:** A customer owes CU300 and is never going to pay. The journal entry is: * **Debit:** Revenue - CU300 * **Credit:** Irrecoverable debts expense - CU300 * **Irrecoverable Debts Written Off and Subsequently Paid:** * Debit: Cash at bank * Credit: Irrecoverable debts expense #### Dishonoured Payments and Irrecoverable Debts * If a customer makes a payment that is not honoured by its bank, reinstate the debt. * Debit: Trade receivables * Credit: Cash at bank * Do not automatically treat a dishonoured payment as an irrecoverable debt. ### Allowance for Receivables #### Section Overview * A receivable is a type of financial instrument. IFRS 9, Financial Instruments, requires companies to create an allowance in the current year in respect of any potential future amounts that will not be recovered from credit customers. * When setting up an allowance for receivables: * Debit: Irrecoverable debts expense * Credit: Allowance for receivables * When a smaller allowance is needed at the end of a subsequent reporting period, reverse the entry: * Debit: Allowance for receivables * Credit: Irrecoverable debts expense #### Definition * **Allowance for Receivables:** An amount in relation to the probability of the non-recovery of debts that reduces the receivables asset to its prudent valuation in the statement of financial position. * An allowance for receivables is a provision for the expected credit losses relating to trade receivables. * Expected credit losses refer to the amount of trade receivables which may not be collected in future due to the risk that customers will default on their debts. * The allowance for receivables is less certain than an irrecoverable debt write-off. An accountant must use judgment to determine the expected future losses relating to trade receivables. * The allowance for receivables is a separate account which is offset against trade receivables, which are shown at the net amount. #### Context Example * Business commences operations on 1 July 20X4, and in the twelve months to 30 June 20X5 makes credit sales of CU300,000 and writes off irrecoverable debts of CU6,000. Cash received from credit customers during the reporting period is CU244,000. * **Total debts owed to the business:** CU300,000 * **Less cash received from credit customers:** (CU244,000) * **Less irrecoverable debts written off:** (CU6,000) * **Trade receivables outstanding at 30 June 20X5:** CU50,000 * **Allowance for receivables:** CU5,000. * **Carrying amount in the statement of financial position:** CU45,000 ### Accounting for Irrecoverable Debts and the Allowance for Receivables #### Section Overview * The irrecoverable debts expense account will be debited with debts written off and with increases in the allowance for receivables. It will be credited with amounts received in respect of debts previously written off, and with reductions in the allowance for receivables. * The trade receivables account is only affected when an irrecoverable debt is written off. It is unaffected by accounting entries related to the allowance for receivables. #### Irrecoverable Debts Written Off: Ledger accounting entries * When it is decided that a particular debt will not be paid, the debt is no longer called a receivable, and becomes an irrecoverable debt. * Debit: Irrecoverable debts expense * Credit: Trade receivables * In the receivables ledger, the personal account of the customer whose debt is irrecoverable will also be adjusted to remove the balance that is not expected to be recovered. In a computerised accounting system, when a debt is written off, the trade receivables balance and the customer's personal account in the receivables ledger will be updated simultaneously. * At the end of the reporting period, the balance on the Irrecoverable Debts Expense Account is transferred to the Profit and Loss Ledger Account (like all other expense accounts). * Debit: Profit and Loss Ledger Account * Credit: Irrecoverable Debts Expense #### Allowance for Receivables: Ledger accounting entries * When preparing the statement of financial position, the credit balance on the allowance for receivables account is deducted from the balance on the trade receivables account. * In subsequent reporting periods, the allowance for receivables will be adjusted as follows: * Carry down the new allowance required in the allowance for receivables account. * Calculate the charge or credit to the statement of profit or loss. * **If the allowance has increased:** * Debit: Irrecoverable debts expense * Credit: Allowance for receivables * **If the allowance has decreased:** * Debit: Allowance for receivables * Credit: Irrecoverable debts expense #### Adjusting the Initial Trial Balance for Irrecoverable Debts and the Allowance for Receivables * **Journal Entry to Write off an Irrecoverable Debt:** Debit Irrecoverable Debts Expense, Credit Trade Receivables. * **Journal Entry to setup an allowance for receivables:** Debit Irrecoverable Debts Expense, Credit Allowance for Receivables. * To adjust the initial trial balance using the columnar approach: * Calculate the amount of Irrecoverable Debts Expense and the required Allowance for Receivables. * Prepare the journal entries to record the expense and the allowance. * Enter these journal entries in the adjustments columns of the trial balance. * Add across to prepare the final trial balance. #### Example: Irrecoverable Debts and the Allowance for Receivables * Harjinder runs a bookshop. Harjinder has extracted the following initial trial balance as at 31 December 20X9. * **Cash at bank:** CU4,391 * **Opening Capital:** CU20,000 * **Loan:** CU2,000 * **Non-current assets:** CU30,000 * **Trade payables:** CU9,642 * **Irrecoverable debt expense:** CU50 * **Expenses:** CU3,896 * **Cost of sales:** CU42,875 * **Sales:** CU96,475 * **Trade receivables:** CU8,622 * **Allowance for receivables:** CU350 * **Drawings:** CU200 * **Suspense:** CU128,667 * **Adjusting the Initial Trial Balance:** * CU695 to be written off. * An allowance of CU250 needs to be set up. * CU200 was banked in respect of a debt which had been written off in the reporting period ended 31 December 20X8. The balance should be reflected as a debit to the cash at bank and a credit to irrecoverable debts expense. * **The adjusted trial balance is as follows:** * **Cash at bank:** CU4,391 * **Opening Capital:** CU20,000 * **Loan:** CU2,000 * **Non-current assets:** CU30,000 * **Trade payables:** CU9,642 * **Irrecoverable debt expense:** CU445 * **Expenses:** CU3,896 * **Cost of sales:** CU42,875 * **Sales:** CU96,475 * **Trade receivables:** CU7,927 * **Allowance for receivables:** CU250 * **Drawings:** CU200 * **Suspense:** CU128,367 * **The profit for the year can be calculated as:** * **Revenue:** CU96,475 * **Less: Cost of sales:** (CU42,875) * **Gross profit:** CU53,600 * **Irrecoverable debts expense:** (CU445) * **Expenses:** (CU3,896) * **Net profit:** **CU49,259** ### Self-Test Questions 1. An irrecoverable debt arises in which of the following situations? * **Correct Answer:: D:** A cheque received in settlement is dishonoured by the customer's bank. 2. An allowance for receivables of CU4,000 is required at the end of a reporting period. The allowance for receivables brought forward from the previous period is CU2,000. What is the impact of the allowance for receivables on profit for the year? * **Correct Answer: C:** Increase by CU 2,000 3. On 1 January 20X5 Plodd had an allowance for receivables of CU1,000. During 20X5 Plodd wrote off debts of CU600 and was paid CU80 by the liquidator of a company whose debts had been written off completely in 20X4. At the end of 20X5 it was decided to adjust the allowance for receivables to CU900. What is the irrecoverable debts expense in the statement of profit or loss for 20X5? * **Correct Answer: B:** CU 580 4. Smith has receivables totalling CU16,000 after writing off irrecoverable debts of CU500 and has an allowance for receivables brought forward of CU2,000. Smith wishes to carry forward an allowance for receivables of CU800. What will be the effect on profit of adjusting the allowance for receivables? * **Correct Answer: C:** CU 1,200 decrease 5. At 31 December 20X9 Folland's receivables totalled CU120,000. Folland wishes to have an allowance for receivables of CU3,600, which is 25% higher than it was before. During the year irrecoverable debts of CU3,200 were written off and irrecoverable debts (written off three years previously) of CU150 were recovered. What is the net charge for irrecoverable debts for the 12-month reporting period ended 31 December 20X9? * **Correct Answer: A:** CU 720 6. During the 12-month reporting period ended 31 December 20X8, Keele decreased its allowance for receivables by CU600. An irrecoverable debt written off in the previous reporting period amounting to CU300 was recovered in 20X8. If the profit for the reporting period after accounting for the above items is CU5,000, what was it before accounting for them? * **Correct Answer: C:** CU5,300 7. Bodkin had the following balances in its trial balance at 30 June 20X1. Trade receivables CU70,000. Irrecoverable debts expense CU500. Allowance for receivables at 1 July 20X0 CU5,000. Bodkin wishes to carry forward at 30 June 20X1 an allowance equal to 10% of trade receivables. What is the irrecoverable debts expense in the statement of profit or loss for the 12-month reporting period ended 30 June 20X1? * **Correct Answer: A:** Charge of CU 2,450 8. Wacko had an allowance for receivables at 1 January 20X0 of CU1,000. It calculates that at 31 December 20X0 an allowance for receivables of CU1,500 is required. In addition, CU2,000 of debts were written off during the reporting period. How much should be included in Wacko's statement of profit or loss in relation to irrecoverable debts expense for the 12-month reporting period ended 31 December 20X0? * **Correct Answer: D:** CU2,550