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Managing Accounts Receivable and Bad Debts: Strategies and Practices

Learn about accounts receivable, credit policies, bad debt management, and provision practices to improve financial health. Understand methods to determine and handle doubtful debts effectively.

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Managing Accounts Receivable and Bad Debts: Strategies and Practices

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  1. Accounts Receivable Provision for bad and doubtful debts

  2. Revision • What is an accounts receivable? • How does an accounts receivable happen?

  3. Accounts Receivable • Accounts receivable same as trade debtor • A/C receivable is a current asset on Balance Sheet. • A/C receivable happens when a business sells goods or services on credit to its clients.

  4. Accounts Receivable • Why giving credit? • Offering credit could increase the amount of overall sales and hence lead to increased profitability. • Competing businesses may offer credit to their customers • More convenient to have credit facilities

  5. Accounts Receivable • Cost of providing credit • Staff cost of running a credit facility • The opportunity cost involved in not receiving the cash immediately. • The cost of allowing discounts for prompt payments • The cost of bad debts when an accounts receivable does not pay

  6. Accounts Receivable • Credit policy • the minimum requirements to grant a credit • The procedure to grant a credit • The number of days given for accounts receivable to pay • The amount of discount for prompt payments • The amount of interest on overdue accounts • The follow-up procedure on overdue accounts

  7. Bad and doubtful debts • Bad and doubtful debts • The accounts receivable that fail to be paid. • An expense to businesses • A cost of providing credits

  8. Bad and doubtful debts Income Statement (extracted) for the year ended 30 June 2008 Revenue 15,000 less: Expenses xxx 2,000 Bad and doubtful debts 1,000 xxx 5,000 8,000 Net Profit 7,000

  9. Case study • 2009 • Jun 1 Credit sale of GST-free goods worth $500 are made to M James • June 30 Statement of account is sent to M James • June 30 the accounting period ends • Aug 1 M James should have settled his account with the business but failed to do so • Aug 31 A reminder letter is sent asking for payment • Sept 30 A letter threatening court action is sent to M James • Oct 20 The account is declared bad Question • Which financial year does the bad debt belong to? 08-09 financial year or 09-10 financial year? WHY?

  10. Case study • According to matching principle, the bad debt belongs to 08-09 financial year. • Bad debt can be dealt with in two ways • Write off directly when they happen; or • According to matching and prudence principle, provide allowance for bad and doubtful debts on balance day.

  11. Provision for doubtful debts • Provision for doubtful debts (allowance for doubtful debts) • enable a proper matching of revenue and expenses • estimate the accounts receivable on balance day how much are unlikely to be paid in the next accounting period.

  12. Provision for doubtful debts • Provision for doubtful debts (allowance for doubtful debts) • Listed on balance sheet • a contra asset account with a normal balance on credit side • as the negative of accounts receivable

  13. Provision for doubtful debts • Balance Sheet (extract) • as at 30 June 2008 Current Assets Cash 10,000 Accounts receivable 5,000 less: Provision for doubtful debts (1,000) 4,000 etc Historical Cost Book value / Net realisable value

  14. Determine the amount of the provision • Factors influence the determination • History of payments • General economic conditions • Economic cycle: boom – recession • Inflation • Interest rate • specific issues related to the industry

  15. Determine the amount of the provision • Methods used to determine the amount of provision for doubtful debts • Specific identification • Percentage of sales • Percentage of accounts receivable • Ageing analysis

  16. Specific identification • Investigate the accounts receivable of each client • Check previous credit rating • Examine the normal payment period of previous accounts receivable • Decide which accounts are doubtful and how much • Total the doubtful amount as provision for doubtful debts • E.g.?

  17. Percentage of credit sales • This is also called the profit and loss statement approach. • It is based on the prior experience of the business. • It is calculated as a percentage of netcreditsales.

  18. Percentage of sales • Example • The credit department of Clara’s Hardware estimates (based on prior experience) that 1% of net credit sales are uncollectible. • Net credit sales for the year just ended were $400,000. • Accounts receivable on balance day $410 000

  19. Percentage of net credit sales • Solution Bad debt expense= 400000x1%=4000 Income statement (extract) Income XX Less expenses Bad debt (4 000) XX

  20. Percentage of accounts receivable • estimate a certain percentage of accounts receivable to be doubtful • Based on past experience and • adjusted for current situation • Use the balance of accounts receivables multiplying the percentage as provision for doubtful debts

  21. Percentage of accounts receivable • Example • A review of previous years' actual accounts shows that bad debts were in line with the historical average of 1.5% of accounts receivables. • Considering the current economic condition, a provision of 2% of accounts receivable is to be raised in the accounts this year. • At 30 June, accounts receivable stand at $209,000.

  22. Percentage of accounts receivable • Solution Provision for doubtful debts = 209000x2%=4180 Balance Sheet (extract) Accounts receivable 209 000 Less Provision for doubtful debts (4 180) 204 820

  23. Ageing analysis • Accounts are analysed to determine how long they have been outstanding. • The longer a debt goes unpaid the less likely it is to be collected.

  24. Ageing analysis • Accounts may be classified as: • Current • 1-30 Days • 31-60 Days • 61-90 Days • Over 90 Days • The total of each age bracket is multiplied by an appropriate loss percentage. • The sum of these amounts represents the balance for the provision for bad debts.

  25. Ageing analysis Example Assume that Laurel Hospital’s past collection experience indicates the following: Length A/C Receivables%uncollectible Current $1,900,000 0.5 1-30 700,000 2 31-60 300,000 3 61-90 700,000 5 90 + 500,000 8 Total $4,100,000

  26. Ageing analysis • Solutions Length A/C Receivables%uncollectibleProvision Current $1,900,000 0.5 9 500 1-30 700,000 2 14 000 31-60 300,000 3 9 000 61-90 700,000 5 35 000 90 + 500,000 8 40 000 Total $4,100,000 107 500

  27. Ageing analysis • Solution Balance Sheet (extract) Accounts receivable 4 100 000 Less Provision for doubtful debts (107 500) 3 992 500

  28. Exercise • P272 7.19

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