Irrecoverable Debts and Allowances for Doubtful Receivables

• Irrecoverable debts are amounts owed to an organisation that it believes it will never receive
• How do irrecoverable debts come about?

  When businesses make credit sales to customers, they agree that the payment for the goods or services sold, can be delayed, for example by 30 or 60 days. This difference between the time of sale and the due date of the payment, creates the possibility of debts not being settled.  
• Why might a customer not pay their sales invoice(s)?

  There are a variety of reasons why customers fail to pay invoice(s). For example, there could be a dispute, a contract may have fallen through or the customer might have gone out of business. 
• Why is it important to record irrecoverable debts?

  Irrecoverable debts increase an organisation’s expenses and reduce the value of its trade receivables. Therefore, it’s important to record them to ensure the financial statements will be a true and fair reflection of the organisation’s accounts. 
• How does an irrecoverable debt effect the statement of profit or loss (SoPL)?

  The sales revenue figure on the SoPL is not affected when a debt is written off as irrecoverable because the sale was still generated. However, its value will be offset by the irrecoverable debt which is an expense, and the organisation’s net profits will be reduced.
• How does an irrecoverable debt effect the statement of financial position (SoFP)?

  If an invoice for a credit sale is unpaid then it doesn’t change the fact that the sale took place and consequently the value of the invoice will be included in the balance of the receivables ledger control account.

  When a debt is written off as irrecoverable, the receivables balance is reduced because the expected funds will not be received. This ensures the current assets on the SoFP are not overstated.
• When should irrecoverable debts be recorded in the accounts?

  As soon as it becomes clear that a debt will not be paid then it’s considered irrecoverable and should be accounted for as such. This could be because the business has exhausted its debt collection procedures to no avail, or it may have been informed that a customer’s business has gone into receivership.
• The allowance for doubtful receivables is a contingency made, or adjusted, at the year end to account for the fact that it’s likely that some of the debts owing to an organisation will not be paid.  
• Specific allowances are made against particular invoices or the balance of individual customers’ accounts about which there are concerns over whether the income will be received. 
• The general allowance is the main contingency that is usually based on an estimate of what percentage of receivables is likely to become irrecoverable. It’s often calculated as a percentage of the year-end balance of trade receivables. 
• Organisations may make specific allowances, a general allowance or have a combination. If there’s more than one allowance, then the total value is calculated and becomes the total allowance for doubtful receivables.  
• At the year end, we may have to make adjustments for both irrecoverable and doubtful receivables. For the accounts to be accurate it’s important to make the adjustments and calculations in the correct order. 
• ADJUSTING FOR DEBTS

  step 1 - Write off the irrecoverable debt

  step 2 - Calculate the total value of any specific allowances

  step 3 - Calculate the remaining value of receivables

  step 4 - Calculate the general allowance

  step 5 - Create the total allowance (specific and general) for doubtful receivables
• Once an organisation has completed its first year of trading and is operating as a going concern it’s likely to have a balance on the allowance for doubtful receivables account each year.   
• Therefore, rather than creating a new allowance every year, the balance on the account is simply adjusting, either up or down, depending on the current year’s requirements.
• WRITING OFF IRRECOVERABLE DEBTS

  step 1 - Calculate the total of any specific allowances and the remaining value of receivables

  step 2 - Calculate the value of the general allowance

  step 3 - Compare the doubtful receivables balance and required allowance

  step 4 - Adjust the balance on the allowance for doubtful receivables account

  step 5 - Statement of profit or loss

  step 6 - Statement of financial position
• Adjusting the allowance for doubtful receivables process

  step 1 - Calculate the value of the general allowance

  step 2 - Compare the doubtful receivables balance and required allowance

  step 3 - Adjust the balance on the allowance for doubtful receivables account

  step 4 - Financial statements