Bad debts

1. Bad debts

2. Bad debts When a business sells to a customer on credit it takes a businessrisk that the customer might not pay the amount owed. A business might have to write off the debt as a bad debt. Bad debts are an expense and will reduce the profit of the business. A business may decide that the debtor cannot pay or the cost of chasing the debt is not cost effective. The debt will then be written out of the ledger.

3. How can a business prevent bad debts for new customers? • Cash sales or cash on delivery • Trade references • Credit references • Bank references • Set a credit limit • Early settlement dates

4. How can a business prevent bad debts for existing customers? • Send regular statements to debtors • Follow up letter • Reminder letter with the threat of taking legal action • Using a third party such as a debt collector • Take legal action in the civil courts • A business could also consider using a factoring firm. The factoring firm would pay the business cash for a proportion of the debtors. The business would not have the problem of chasing debtors for payment.

5. Accounting entries Debit - bad debts account Credit - personal account of the debtor John Green Bal b\d 6,000 Bad debts 6,000 Bad debts account John Green 6,000 Profit and loss a\c 6,000

6. Accounting entries • A debtor may agree to pay some of the debt and the firm will write off the remainder of the debt. • John Davy a debtor owes £5,000 and agrees to pay 40 pence in the £. The remainder of his debt will be written off. The following journal entries would be made: • Journal • Dr Cr • £ £ • Bad debts 3,000 • John Davy 3,000 • Bank 2,000 • John Davy 2,000

7. Provision for bad and doubtful debts A business should make an estimate of the amount of debt that might not be recovered. The accountant will create a provision for doubtful debts in the ledger. When creating a provision the concept of prudence is applied. The profit of the business will not be overstated. Debtors will be shown at a true and fair value in the balance sheet.

8. Factors to consider when creating a provision • Customer history • Type of customer • Size of the debt • Geographical position of the debtor • Interest rates • General economic factors • Expert knowledge of the business sector

9. Factors to consider when creating a provision It is common practice for a business to produce an analysis of debtors called an ageddebtor analysis. This shows the amount of time debts have been outstanding. A business will adopt a practical approach by taking a fixed percentage of debtors. For example the accountants estimate that 5% of the debtors could be bad. Total debtors £500,000 5% Provision £25,000 The accountants estimate that the asset of debtors is £475,000.

10. The accounting entries to create a provision for doubtful debts Debit - profit and loss account Credit - provision for doubtful debts account With the full amount of the provision Total debtors £500,000 5% provision Provision for doubtful debts account Bal c\d 25,000 Profit and loss 25,000 25,00025,000 Bal b\d 25,000

11. Provision for doubtful debts Debtors must be shown in the balance sheet at the net figure. Balance sheet extract Current assets Debtors 500,000 Less provision for doubtful debts 25,000 475,000 The prudence concept has been applied and the debtors’ figure is not overstated.

12. The accounting entries to increase the provision • The accountant may decide that the provision is not enough and must be increased: • Debit - profit and loss account • Credit - provision for doubtful debts account • only with the amount of the increase • If the total debtors have increased to £800,000 and the business maintains a 5% provision on debtors:

13. Entries to increase the provision Provision for doubtful debts account Bal c\d 40,000 Bal b/d 25,000 Profit and Loss 15,000 40,00040,000 Bal b/d 40,000 Current assets Debtors 800,000 Provision for doubtful debts 40,000 760,000

14. Entries to reduce the provision The accountant may decide that the provision is too high and will need to be reduced. Debit - provision for doubtful debts account Credit - profit and loss account only with the amount of the reduction. This will increase the profit. The amount of the reduction should be added to the gross profit in the trading and profit and loss accounts. If the total debtors reduced to £600,000 and a 5% provision is maintained:

15. Entries to reduce the provision Provision for doubtful debts account Profit and Loss 10,000 Bal b/d 40,000 Bal c/d 30,000 40,00040,000 Bal b/d 30,000 Current assets Debtors 600,000 Provision for doubtful debts 30,000 570,000

16. Aged debtors analysis • A business can produce an analysis of the age of debtors in the business. It can then use the analysis to decide upon: • The amount of bad debts to be written off • The amount of the provision • AS students may be required to use the aged debtors analysis in the exam to calculate the amount of bad debts and the provision for doubtful debts.

17. Aged debtors schedule Example: Age of the debtTotal debtors £ Up to 30 days 20,000 31 to 60 days 18,000 61 to 90 days 15,000 Over 90 days 6,000

18. Aged debtors analysis Policy: Age of the debtAmount of provision (%) Up to 30 days Nil 31 to 60 days 5 61 to 90 days 10 Over 90 days 20

19. Aged debtors analysis Calculation: Age of the debtAmount%Provision Up to 30 days 20,000 0 0 31 to 60 days 18,000 5 900 61 to 90 days 15,000 10 1,500 Over 90 days 6,000 20 1,200 Total of provision 3,600

20. Tasks • Complete task sheet and OCR exam question.