Irrecoverable Receivables Notes

Irrecoverable Receivables

Introduction

By the end of this chapter, you should be able to:

• Understand the role of credit control.
• Calculate and record the writing off of irrecoverable receivables.
• Calculate and record an allowance for irrecoverable receivables and any amounts subsequently recovered.

Irrecoverable receivables are debts that will not be paid and therefore have to be written off as a debit in the income statement.

Allowance for irrecoverable receivables (doubtful debts) means that the asset called receivables is of uncertain value, and adjustments need to be made in the accounts to cover the possibility of some debts becoming bad in the future. As there is still some hope that it will be paid, it is not yet written off but is still kept as an asset in the receivables account.

4.1 Credit Control

A business that sells goods on credit should ensure customers pay their accounts on time. Good practice will include:

• Checking that a new customer has a satisfactory credit history before allowing them to buy on credit.
• Having clear guidelines for customers as to when payment is expected (e.g., 30 days after delivery).
• Checking regularly what cash has been received and having credit control procedures to chase overdue amounts.

At regular intervals and at the financial year-end, it is good practice for a business to list all the balances of amounts owed to the business by its customers and show how long each debt is outstanding. This list is known as an aged receivables list.

Aged Receivables List Example:

Note that M. O'Sullivan owes the business £750, and the amount has been outstanding for two months. This means that the business sold goods on credit to M. O'Sullivan two months ago and that M. O'Sullivan has still not paid for these goods.

The business should check to see which customers have not paid within the business's set credit limit (often 30 days) and issue reminders to them either by letter, email, or telephone. If customers do not pay their invoices on time, then the business may stop supplying that customer. Legal action may also be taken. Investigation into why debts are not paid on time may lead to writing off the debt as an irrecoverable receivable.

4.2 Writing Off Irrecoverable Receivables

An irrecoverable receivable (bad debt) is recorded in the accounts when a business decides a customer will not pay for a good or service bought on credit. It is often the final stage of a long process involving reminders, threats of legal action, and lawyers' letters.

Irrecoverable receivables are recorded in the income statement as an expense and deducted from receivables in the balance sheet. Receivables are amounts due from credit customers.

• Dr Irrecoverable receivables (income statement account)
• Cr Receivables (balance sheet account)

This aligns with the accruals concept because it's important to match all expenses or losses to the accounting period to which they relate.

Activity 4.1: Accounting for an Irrecoverable Receivable

George Grey's business, Newport Novelties, had a long-term outstanding debt of £380 from a customer, Peter Hinds. After paying a solicitor to send Peter a letter of demand, George was finally informed that Peter had left the country. As a result, George reluctantly decided to write off the debt at 31 December 20X2, the last day of the accounting period. The total receivables at this date, including Peter's, amounted to £4,560. This irrecoverable receivable was the first that George had suffered since opening the business.

4.2.1 Subsequent Recovery of an Irrecoverable Receivable

Sometimes, a debt written off as an irrecoverable receivable will be recovered or partly recovered. For example, a debt of £1,000 owed by a company that has gone into liquidation is written off as an irrecoverable receivable. Six months later, it is announced that the company will pay 20p in the pound on all debts. Therefore, £200 will be received, and the following entries need to be made in the general ledger to record this:

• Dr: Receivables £200
• Cr: Irrecoverable receivables £200

When the £200 is received, the entries in the general ledger will be:

• Dr: Cash £200
• Cr: Receivables £200

4.3 Allowance for Irrecoverable Receivables

A business can never be certain that all its customers are going to pay the amounts that they owe to the business.

The total amount owed by all customers is called receivables. Receivables are shown under current assets in the balance sheet. Each customer that buys goods on credit has its own account, and the balance of each customer's account will show how much the customer owes the business.

Experience may suggest that some percentage of customer balances will not be received. For instance, a local newspaper may find that on average, 3% of the balances on its receivables ledger, after writing off irrecoverable debts, will not be received. The possible loss resulting from this should therefore be provided for in its income statement. This provision is referred to as an allowance for irrecoverable receivables.

Example: Allowance for Irrecoverable Receivables

At the end of M. Wilson's first year of trading, she lists all the amounts due from customers, which total £165,800. After writing off an irrecoverable receivable of £200, she estimates (after taking advice from a friend operating in the same trade) that 1% of her customers will not pay the amounts owing. She, therefore, estimates that £1,656 may not be received – 1% of (£165,800 − £200) = £1,656 – and she needs to open an account called Allowance for irrecoverable receivables in the general ledger to record this.

• Dr: Allowance for irrecoverable receivables (income statement) £1,656
• Cr: Allowance for irrecoverable receivables (balance sheet) £1,656

The result will be that £1,656 will be charged as an expense against profit in the income statement. A credit balance of £1,656 will be carried down in the general ledger at the end of the year to create an opening balance at the beginning of the next accounting year. In the balance sheet, the allowance for irrecoverable receivables will be deducted from receivables.

At the end of each accounting year, the allowance for irrecoverable receivables will be recalculated, and the balance on the allowance for irrecoverable receivables will be increased or reduced as necessary. It is the increase or decrease in the allowance that will be taken to the income statement. In the balance sheet, the full new allowance will be deducted from receivables.

• To increase the allowance:
  • Dr: Allowance for irrecoverable receivables (income statement)
  • Cr: Allowance for irrecoverable receivables (balance sheet)
• To reduce the allowance
  • Dr: Allowance for irrecoverable receivables (balance sheet)
  • Cr: Allowance for irrecoverable receivables (income statement)

Following on from the example above, at the end of year 2, M. Wilson has amounts owing from customers of £285,250. One customer has written to her to say that, due to financial difficulties, he is unable to pay his account of £250. This amount, therefore, has to be shown under expenses in the income statement as an irrecoverable receivable. The accounting policy of writing off 1% of customers' balances proves to be a good estimate and will again have to be accounted for at the end of year 2.

Total due from customers at the end of year 2: $285,250$
Less: Irrecoverable receivable: $250$
Total: $285,000$
Allowance for irrecoverable receivables (1% x £285,000): $2,850$
Brought forward balance: $1,656$
Increase in allowance for irrecoverable receivables: $1,194$

General Ledger (Year 2)

Irrecoverable Receivables (Expense)

• 20X2
  • Dec 31: Dr Receivables $250$
  • Dec 31: Cr Income statement $250$

Allowance for Irrecoverable Receivables (Balance Sheet Account)

• 20X2
  • Jan 1: Cr Balance b/d $1,656$
  • Dec 31: Dr Balance c/d $2,850$
  • Dec 31: Cr Allowance for irrecoverable receivables $1,194$
    Balance b/d $2,850$

Allowance for Irrecoverable Receivables (Expense)

• 20X2
  • Dec 31: Dr Allow for irrecoverable receivables $1,194$
  • Dec 31: Cr Income statement $1,194$

Activity 4.2: Calculating an Allowance for Irrecoverable Receivables

At the end of year 3, M. Wilson has amounts owing from customers of £190,000. One customer has been declared bankrupt; therefore, the amount owing from her of £400 will have to be written off as an irrecoverable receivable. The accounting policy of writing off 1% of customers' balances still applies.

Activity 4.3: Accounting for Irrecoverable Receivables

George Grey's business, Newport Novelties, had the following balances on its receivables ledger at the end of each of the following years. These balances were after irrecoverable receivables had been written off but before providing an allowance for irrecoverable receivables:

• 20X1 £4,600
• 20X2 £5,320
• 20X3 £4,840

George used an estimate of 5% of total receivables to calculate the allowance for irrecoverable receivables at the end of each of the three years:

• 20X1 £230 (£4,600 × 5%)
• 20X2 £266 (£5,320 × 5%)
• 20X3 £242 (£4,840 × 5%)

For each of:

• a. 20X1
• b. 20X2
• c. 20X3
  • i. Prepare the general ledger accounts for the financial year 31 December.
  • ii. Show how receivables should be presented in the balance sheet at 31 December.
  • iii. Show how the changes in the allowance for receivables should be presented in the income statement for the year ended 31 December.

In the income statement, the irrecoverable receivables will be shown as an expense (a debit), and the decrease in the allowance for irrecoverable receivables will be a negative number (a credit). In the balance sheet, the irrecoverable receivables are deducted first from receivables, then the full allowance for irrecoverables (not just the change in the allowance) is deducted.

Activity 4.4: Presenting Irrecoverable Receivables in the Financial Statements

Claudine runs an interior design business. The following is an extract from her accounting records:

Show how the information will be reflected in Claudine's income statement and balance sheet in each of the years 20X5 to 20X7.

4.4 The Extended Trial Balance Revisited

The following example allows you to build on your knowledge of extended trial balances gained in Book 2 and appreciate how many of the adjustments to the trial balance explained in this book are dealt with in the extended trial balance.

Example: Accounts Preparation Using an Extended Trial Balance

John Black has extracted a trial balance from his general ledger for the year ended 30 June 20X5.

Trial Balance:

• Sales $263,000
• Purchases $198,000
• Opening inventory $9,600
• Carriage inwards $1,960
• Rent $12,600
• Heating and lighting $3,250
• Advertising $2,090
• Office expenses $1,060
• Carriage outwards $980
• Discount allowed $2,540
• Loan interest $1,010
• Motor vehicle $32,480
• Accumulated depreciation – motor vehicles $14,210
• Furniture $6,100
• Accumulated depreciation – furniture $3,660
• Receivables $16,650
• Bank account $6,450
• Loan $9,850
• Payables $6,400
• VAT $13,000
• Capital account $17,500
• Drawings $32,850

Additional Information:

1. The closing inventory is valued at a cost of $10,500.
2. The electricity bill for June has not yet been received. Mr. Black estimates that, based on past experience, an accrual of $300 will be needed in the accounts.
3. Rent of $3,000 has been paid for the period 1 June to 31 August.
4. Depreciation on the motor vehicle is provided at 25% per annum on the reducing balance method.
5. Depreciation on furniture is provided at 10% per annum on the straight-line basis.
6. Mr. Black estimates that $850 due from Street Limited will not be received because he has heard that the business is in financial difficulties.
7. No allowance for irrecoverable receivables is to be made.

Note: Everything in the trial balance above goes into the financial statements once because the trial balance is the result of double-entry bookkeeping. All the additional information after the trial balance is entered in the financial statements twice: one debit and one credit.

Accounting Adjustments:

1. The closing inventory is $10,500. Dr: Closing inventory in the balance sheet. Cr: Closing inventory in the income statement.
2. The electricity bill accrual for June of $300. Dr: Heating and lighting. Cr: Accruals.
3. Rent of $3,000 has been paid for the quarter commencing 1 June. A prepayment for two months is $3,000 imes 2/3 = 2,000. Dr: Prepayments. Cr: Rent.
4. Depreciation:
   • Motor vehicle 25% p.a. on the reducing balance: cost $32,480 less accumulated depreciation to date $14,210 = 18,270 multiplied by 25% = $4,567.50. As accounts are prepared in round pounds, this is rounded up to $4,568. Dr: Depreciation in the income statement. Cr: Motor vehicle accumulated depreciation in the balance sheet.
   • Furniture 10% p.a. on a straight-line basis: cost $6,100 multiplied by 10% = $610. Dr: Depreciation in the income statement. Cr: Furniture accumulated depreciation in the balance sheet.
   • Total depreciation for the year (motor vehicles $4,568 + furniture $610) = $5,178.
5. It is estimated that $850 of receivables will not be recovered. Dr: Irrecoverable receivables. Cr: Receivables.

Income Statement:

• Sales $263,000
• Less: cost of sales
  • Opening inventory $9,600
  • Add: Purchases $198,000
  • Carriage inwards $1,960
    • $209,560
  • Less: Closing inventory $10,500
    • $199,060
• Gross profit $63,940
• Less: Expenses
  • Rent $10,600
  • Heating and lighting $3,550
  • Advertising $2,090
  • Office expenses $1,060
  • Discount allowed $2,540
  • Depreciation $5,178
  • Carriage outwards $980
  • Irrecoverable receivables $850
  • Loan interest $1,010
    • $27,858
• Net profit $36,082

Balance Sheet: