Reviews of trade receivables
A business’ bookkeeper or accountant should review its customer debts at its accounting period-end to ensure that the business does not overstate how much will be collected from them.
In Bookkeeping Part 2, we saw how some debts may be written off as irrecoverable where we are sure that money will not be collected. In this situation, the debt is written off as an expense and is cancelled in the Sales Ledger so that no further time or costs will be wasted trying to collect the money.
Recording an irrecoverable debt
The gross amount to be written off will be credited to the Sales Ledger Control Account in the General Ledger (and to the credit side of the customer account in the Sales Ledger). The net amount of the debt will be debited to the Irrecoverable Debts account and the VAT to the VAT account in the General Ledger.
A business’ customer, John Smith, has gone bust owing £1,200 and the business does not expect any of this to be paid. It will therefore record the following journal to write this amount off.
The above journal would then be posted into the General Ledger and the £600 credit will be recorded in the John Smith account in the Sales Ledger.
General Ledger accounts
Sales Ledger account
There can be, however, situations where we are less certain that a debt might be paid. An accountant might believe that:
- a debt is unlikely to be collected but efforts should still be made to try and collect it; or
- a certain portion of debts are unlikely to be collected but it is impossible to determine which customers will not pay
Where this is the case a business must adjust for these “doubtful debts” so that the business does not overstate the value of its customer debts but still records them as being outstanding so that the business will still attempt to collect them. This can be achieved by creating an allowance for doubtful debts.
When recording doubtful debts in a business’ General Ledger an accountant will use two ledger accounts; the Allowance for Doubtful Debts Account and the Allowance for Doubtful Debts Adjustment Account.
Allowance for doubtful debts account
The Allowance for Doubtful Debts Account is a negative asset account and should record the amount of the customer balances that the business doubts will be received. A balance carried down on this account will always be recorded on the debit side and the balance brought down will always be recorded on the credit side.
Allowance for doubtful debts adjustment account
When a debit or credit is posted to the Allowance for Doubtful Debts Account, the corresponding debit or credit will be sent to the Allowance for Doubtful Debts Adjustment Account. This account is an expense account and any balance on this account will end up being posted to the Profit & Loss account.
[NB. Some accountants and bookkeepers will use the Irrecoverable Debts account rather than the Allowance for Doubtful Debts account]
Types of doubtful debt
There are two types of doubtful debts allowance; specific and general
A specific doubtful debts allowance is required where an accountant has identified a particular client who is considered unlikely to pay
A general doubtful debts allowance is required where an accountant believes that a portion of customer debts will not be paid but is unable to identify which specific customers are unlikely to pay.
This is often required where a business has a large number of customers who owe relatively small amounts. In such a situation, past experience might indicate that a particular percentage of customers won’t pay each year, but the business might have little idea as to which customers fall into this category.
Calculating the allowance for doubtful debts
The allowance for doubtful debts is calculated as the total of the specific and general doubtful debts.
At its year-end, a business is owed £80,000 by its customers. The business’ accountant reviewed the customer list of balances and identified the following:
- A customer debt of £5,000 has gone bad and needs to be written off as irrecoverable
- A customer that owes £3,000 is in financial trouble and as there is a risk that this will not be received it is decided to make a specific allowance against the debt
- Past experience indicates that a general allowance of 2% is required
Step 1: Irrecoverable debts should be written off first – remember that an irrecoverable (or bad) debt is not a doubtful debt.
Step 2: Calculate the general doubtful debts allowance as follows. Start the with the Sales Ledger balances after the irrecoverable debts have been written off and then deduct any specific allowances. Then multiply this amount by the general allowance percentage
|Sales ledger balances (£80,000 – £5,000)||£75,000|
|Less specific allowances||£3,000|
|General allowance (£72,000 x 2%)||£1,440|
Step 3 Add the general allowance calculated in step 2 to the specific allowances
|Allowance for doubtful debts||£4,440|
The business therefore expects to receive £70,560 from the amount owed to it by its customers at the year-end (i.e. £75,000 less £4,440).
In the next page of this section we shall look at how doubtful debts are posted in the General Ledger.