doubtful & bad debts
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DOUBTFUL & BAD DEBTS
ADJUSTMENT ENTRIES
MUTHU
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BAD DEBTS IRRECOVERABLE DEBTS
An entity may not be able to recover its balancesoutstandingin respect of certain receivables.In accountancy, it refer to such receivables asIrrecoverable Debts or Bad Debts.
Bad debts could arise for a number of reasonssuch as customer going bankrupt, trade dispute orfraud.
Every time an entity realizes that, it unlikely torecover its debt from a receivable, it must 'write off'the bad debt from its books.This ensures that the entity's assets (i.e.receivables) are not stated above the amount, itcan reasonably expect to recover which is in line
with the concept of prudence.
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Debit
Bad Debt Expense
Credit Receivable
The credit entryreduces the receivable balance
to nilas no amount is expected to be recovered
from the receivable.
The debit entryhas the effect of cancelling theimpact on profit of the sales that were previously
recognized in the income statement.
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EX
ABC Ltd sells goods to DEF Ltd for Rs.500 on credit.
ABC Ltd subsequently finds out that DEF Ltd is being
liquidated and therefore the prospects of recovering
its dues are very low.Rs. Rs.
Debit Bad Debt Expense 500
Credit To DEF LTD (Receivable) 500
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BAD DEBT RECOVERED
Occasionally, a bad debt previously written offmay subsequently settle its debt in full or in
part.
In such case, it will be necessary to canceltheeffect of bad debt expense previously
recognized up to the amount settlement.
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EX
ABC Ltd sells goods to DEF Ltd for Rs.500 oncredit. ABC Ltd subsequently finds out that
DEF Ltd is being liquidated and therefore the
prospects of recovering its dues are very low.ABC Ltd therefore writes off the receivable
from its books. However, the administrator
appointed to oversee the liquidation of DEF Ltdinstructs the company to pay Rs.300 to ABC
Ltd in full settlement of its dues.
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ENTRY
As Rs.300 of the bad debt has been recovered,it is necessary to cancel the effect of previously
recognized bad debt expense up to this
amount.
Rs. Rs.
Debit Cash 300
Credit
Bad Debt Recovered (Income)
300
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SPECIFIC ALLOWANCE
This is allowance created in respect of specific
receivables which are known to be facing
serious financial problems or have a trade
disputewith the entity.
Such balances may be identified by examining
an aged receivable analysis which details the
time lapsedsince the creation of a receivable.
Long outstanding balances identified from suchanalyses could be considered for inclusion in
the allowance for doubtful debts.
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CONT..
The difference between the treatmentof a bad debtand a specific allowance for doubtful debt is that inthe latter case, the receivable ledger of the specificdebt is not removed in case the debtor actuallypays whereas in the case of bad debts, thereceivable ledger is reduced to nil.Also, specific allowance may not be created for theentire amount of the doubtful receivable but only aportion of it.
For instance, if there is a 50% chance ofrecovering a doubtful debt in respect of a certainreceivable, a specific allowance of only 50% maybe required. On the contrary, bad debt is normally
recognized in full.
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GENERAL ALLOWANCEPast history of a business may show that a portion ofreceivable balances is not recovered due to unforeseencircumstances.
Therefore, it may be prudent to create a generalallowance for doubtful debts in addition to the specificallowance.
The general allowance may be calculated on the basis ofpast experience concerning recoverability of debts.
The practice of creating general provisions is on thedecline after revisions in the International FinancialReporting Standards (IFRS).
Specifically, IAS 39 prohibits creation of generalprovisions on the basis of past experience due to thesubjectivityinvolved in creating such an estimate.
Instead, reporting entity is required to carry out
impairment reviewto determine the recoverability of the
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ACCOUNTING FOR DOUBTFUL DEBTS
Allowance for doubtful debts is created byforming a credit balance which is netted off
against the total receivables appearing in the
balance sheet.A corresponding debit entry is recorded to
account for the expense of the potential loss.
Debit
Allowance for Doubtful Debts (Expense)
Credit
Allowance for Doubtful Debts (Balance
Sheet)
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CONT
Once an allowancefor doubtful debts has beencreated, only the movement in the allowance
will need to be charged to the income statement
in future accounting period.So if estimated allowance for doubtful debt is
same as last accounting period, no accounting
entry will be required in the current period asthe total receivables will be reduced by the
amount of allowance which has already been
created.
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EX
ABC LTD has trade receivable of worthRs.50,000 as at 31 December 2010.
XYZ LTD, a receivable owing Rs.10,000 to ABCLTD at the year end, has been recently been
wound up.Consequently, ABC LTD does not expect torecover the amount due from XYZ LTD.
Based on past experience, ABC LTD estimatesthat 5% of its receivables will default.
Allowance for doubtful debts on 31 December2009 was Rs.1500.
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ABC LTD must write off the Rs.10,000
receivable from XYZ LTD as bad debt
Rs.
Rs.
Debit
Bad Debt Expense
10,000
Credit
XYZ LTD (Receivable)
10,000
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Note that Rs.10,000 in respect of receivable
from XYZ LTD has been excluded from the
calculation of the general allowance as it has
already been written off in full.
Bad Debt Expense
Debit Rs. Credit Rs.
XYZ LTD (Receivable) 10,000Income Statement 10,000
10,000 10,000
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XYZ LTD Receivable
Debit
Rs.
Credit
Rs.
Sales
10,000
Bad Debt Expense
10,000
10,000
10,000
Allowance for Doubtful Debts
Debit Rs. Credit Rs.
Balance c/d
2,000
Balance b/d
1,500
Income Statement 500
2,000 2,000