Bad Debts, Allowances for Doubtful Debts, and Allowances for Prompt Payment Discounts

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Bad Debts and Allowance

Definition and Recognition of Bad Debts

When businesses sell goods or services on credit, there is a risk that some customers will not pay their debts. These uncollectible amounts are known as bad debts or irrecoverable debts. Once it is clear that a debt will not be collected, it must be written off from the accounting records.

Bad Debt: An amount owed by a customer that is considered uncollectible and must be removed from the books.
Write-off Process: Debit the Bad Debts Expense account and credit the customer’s account (removing the asset).
Income Statement Impact: Bad debts expense is reported as an operating expense.
Balance Sheet Impact: Trade receivables are reduced by the amount written off.

Example: If a business has trade receivables of £52,000 and writes off £1,900 as bad debts, the balance sheet will show trade receivables of £50,100.

Doubtful Debts and Allowance for Doubtful Debts

Definition and Purpose

Not all uncollectible debts can be specifically identified in advance. Doubtful debts are amounts that may become bad debts in the future. To account for this uncertainty, businesses create an allowance for doubtful debts (also called a provision for doubtful debts).

Doubtful Debts: Amounts owed by customers that may not be collected, but are not yet written off.
Allowance for Doubtful Debts: An estimate of the amount of trade receivables that may become bad debts, based on past experience and current conditions.
Accounting Concepts: The prudence concept (do not overstate assets) and the accrual basis (match expenses to revenues) justify the creation of this allowance.

Calculation Methods

The allowance can be calculated using an Aged Debtors Report, which analyzes receivables by the length of time outstanding and applies different percentages based on experience.

Period Outstanding	Total Receivable (£)	Percentage Doubtful	Allowance (£)
0–30 days	5,000	1%	50
31–60 days	3,000	2%	60
61–90 days	1,100	4%	44
Over 90 days	540	10%	54
Total	9,640		208

In the balance sheet, the allowance is deducted from trade receivables to show the net realizable value.

Setting Up and Adjusting the Allowance

Initial Setup: Debit Bad Debts Expense, Credit Allowance for Doubtful Debts for the full amount.
Increasing Allowance: Debit Bad Debts Expense, Credit Allowance for Doubtful Debts for the increase.
Decreasing Allowance: Debit Allowance for Doubtful Debts, Credit Bad Debts Expense for the decrease.

Example: If trade receivables are £40,000 and 3% are estimated doubtful, the allowance is £1,200. If the next year, receivables are £50,000 and the allowance should be £1,500, the increase is £300.

Financial Statement Presentation

Income Statement: Shows bad debts written off and the increase (or decrease) in the allowance as expenses.
Balance Sheet: Trade receivables are shown net of the allowance for doubtful debts.

Summary Table: Bad and Doubtful Debts in the Income Statement

Item	Effect
Bad debts written off	Expense
Increase in allowance	Expense
Decrease in allowance	Reduces expense
Bad debts recovered	Reduces expense (or shown as other income)

Alternative Approaches to Allowance Entries

Some systems debit or credit the profit and loss account directly for changes in the allowance, rather than using the bad debts expense account. The final impact on the financial statements is the same.

Bad Debts Recovered

Accounting for Recovery

If a previously written-off debt is recovered, the following entries are made:

Reinstate the debt: Debit Customer’s account, Credit Bad Debts Recovered.
Record cash received: Debit Cash at Bank, Credit Customer’s account.

If the amount is material, it is shown as other income; if immaterial, it may be netted against bad debts expense.

Allowances for Prompt Payment Discounts

Definition and Accounting Treatment

Businesses may offer prompt payment discounts (also called settlement or cash discounts) to encourage early payment. Under IFRS 15, sales revenue should be reported net of such discounts.

Initial Sale: Record at full price unless it is likely the discount will be taken.
If Discount Taken: Debit Discounts Allowed and Cash at Bank, Credit Customer’s account.
Year-End Allowance: Estimate the value of discounts likely to be taken on outstanding receivables and set up an allowance.

Example: If £190,000 of receivables are less than 10 days old, 40% are likely to take a 2% discount, the allowance is £1,520. This is deducted from trade receivables in the balance sheet.

Accounting Entries for Allowance

Initial Setup: Debit Discounts Allowed, Credit Allowance for Prompt Payment Discounts.
Increase in Allowance: Debit Discounts Allowed, Credit Allowance for Prompt Payment Discounts (for the increase).
Decrease in Allowance: Debit Allowance for Prompt Payment Discounts, Credit Discounts Allowed (for the decrease).

Summary of Key Points

Bad debts are written off when deemed uncollectible, reducing both receivables and profit.
An allowance for doubtful debts is created to estimate future bad debts, based on evidence and experience.
Changes in the allowance are reflected as expenses or reductions in expenses in the income statement.
Bad debts recovered are treated as income or as a reduction of bad debts expense.
Allowances for prompt payment discounts are estimated and deducted from trade receivables in the balance sheet.

Key Journal Entries

Writing off a bad debt:
Setting up allowance for doubtful debts:
Increasing allowance for doubtful debts:
Decreasing allowance for doubtful debts:
Bad debt recovered:
Setting up allowance for prompt payment discounts:

Formulas

Allowance for Doubtful Debts:
Allowance for Prompt Payment Discounts:

Additional info:

All estimates for allowances should be based on historical data, industry averages, and current economic conditions.
Materiality should be considered when deciding how to present bad debts recovered.