Accounting for Adjustments –

Bad debts & doubtful debts

2 Learning outcome

 By the end of this topic, students will be able to:

1. Differentiate between bad debts and doubtful debts.
2. Post transactions for provision of doubtful debts.
3. Construct an extract of Statement of Profit & Loss and Balance Sheet.
3 Bad Debts & Doubtful Debts
Bad Debts
 Bad debts are those debtors that the business knows which will not pay their
outstanding debts.
 These debts are not expected to be received in the future due to a number of
reasons.
 For example, the business is unable to locate the debtor, the business received
notification that the debtor has been declared bankrupt or the balance has been
outstanding for a long period of time.

Doubtful Debts
 Doubtful debts are those debts that, while not yet considered to be irrecoverable,
are considered likely to become future bad debts.
 Other Possible Scenarios
4

Debtor refuse to
Debtor refuse to
pay one of a
pay part of an
number of
invoice
invoices

Debtor indicate
that only a
Debtor’s business
proportion of total
has failed
amount due will
be paid
5 Bad Debts

 Bad debts are a business expense.

 Must be charged to the income statement as an expense when calculating the net profit or
loss for the period.
 Bad debts need to be removed from the asset account – debtor’s account.
 If a debt is found “bad”, it reduces the balance of debtor to zero, the debtor’s account is
closed.
 Double entry:

Expenses increase Debit: Bad Debt Account

Asset decrease Credit: Account Receivable
 Example 1
6
7 Journal entry

Debit Credit
 Debit: Bad debt expense 770
 Credit: C. Bloom 520
 Credit: R. Shaw 250
8 Allowance for doubtful debts

To show in the
To charge as an
balance sheet a
expense for that
debtors figure as
year showing debts
close as possible to
that will never be
the true value of
paid
debtors

Why
allowances
are needed?
9 Allowance for doubtful debts (Cont.)

 The accountant must estimate such future bad debts arising out of revenue earned
in the current accounting period.
 This will ensure that this expense, known as Doubtful Debts, will be allocated to
the accounting period in which the actual revenue has been recorded.
 The Allowance for Doubtful Debts which arises ensures that a reasonable
estimate of Debtors that will eventually be collected in cash is recorded in the
Balance Sheet. This reflects the Prudence concept.
 The bad debts expense will be written off in the accounting period in which it
occurs.
10 Allowance for doubtful debts (Cont.)
In practice, how does the accountant determine how much to allow for Doubtful
Debts?
 A knowledge of individual debtors. This is time-consuming, as each individual
debtor’s account would need to be assessed.
 The experience gained from past accounting periods will give the accountant a
reasonable idea of what percentage of debtors, on balance day, may not settle their
accounts.
 Basing the decision on a process referred to as “ageing of debtors”. This method
groups outstanding accounts according to how long each debtor’s account has
been outstanding. The principle is that the longer the amount has been owing, the
more likely that the debtor may not pay.
 The economic climate of the time also plays an important part. If money is ‘tight’
and credit is hard to come by, the likelihood of a greater number of debtors not
settling their accounts is enhanced.
11 Accounting Entries for Allowances for
Doubtful Debts
 Year in which the allowance is first made:

Debit Profit and Loss account with the amount of the allowance (deduct it from
gross profit as an expense)
Credit Allowance for Doubtful Debts Account
12 Example 2

 At 31 December 2017, the accounts receivable figure after deducting bad debts was
RM10,000. It is estimated that 2% of debts (RM200) will eventually prove to be bad
debts, and it is decided to make a provision for these.

Balance will be deducted from the

accounts receivable total
13 Example 2 (cont.)

From “Profit and

Loss account”

From the
balance of
“Allowance for
doubtful debts”
account
14
1. Bad Debts Account

• To show how much is being written-off as bad debts.

• This expenses account is used when a debt is believed to be
irrecoverable and is written-off.

2. Allowance for Doubtful Debts Account

• To show how much is being treated as an allowance for doubtful

debts.
• This account is used only for estimates of the amount of debt
remaining at the year end (after the debts have been written off)
that are likely to finish up as bad debts.
15

Both (1) and (2) will be These amounts are shown as

charged in the income deductions from the gross
statement. profit.

By deducting (2) from the accounts

receivable in the balance sheet, we get
a net figure, which represents a more
accurate figure of the value of
accounts receivable.
16 Increasing the allowance

 Refer to Example 2, assume that at the end of December 2018, the allowance for doubtful
debts needed to be increased.
 This was because the allowance was kept at 2%, but the accounts receivable figure had
risen to RM12,000.
 An allowance of RM200 had been brought forward from the previous year, but we now
want a total allowance of RM240 (2% of RM12,000).

Debit Profit and Loss account with the increase in the allowance (deduct it from gross
profit as an expense)

Credit Allowance for Doubtful Debts Account

17 Example 3

Amount
increase in
allowance

2% allowance
based on
RM12,000 of
accounts
receivable
18 Example 3 (Cont.)

Amount
increase in
allowance

2% allowance
based on
RM12,000 of
accounts
receivable
19 Reducing the allowance

 To reduce the allowance, you simply do the opposite to what you did to increase it.
 Therefore, to reduce it we would need a debit entry in the allowance account. The credit
would be in the profit and loss account.
 (Refer to Example 3), Let’s assume that at 31 December 2019, the figure for accounts
receivable had fallen to RM10,500 but the allowance remained at 2%, i.e. RM210 (2% of
RM10,500).
 As the allowance had previously been RM240, it now needs to be reduced by RM30. The
double entry is:

Debit Allowance for Doubtful Debts Account

Credit Profit and Loss account (i.e. add it as a gain to gross profit_
20 Example 4

Amount
reduced in
allowance

2% allowance
based on
RM10,500 of
accounts
receivable
21 Example 4 (cont.)

Amount reduce
in allowance

2% allowance
based on
RM10,500 of
accounts
receivable
22 Comprehensive Example
 A business starts on 1 January 2010 and its financial year end is 31 December annually. A table of
the accounts receivable, the bad debts written off and the estimated bad debts at the rate of 2% of
accounts receivable at the end of each year is now given. The double entry accounts and the
extracts from the financial statements follow.

Year to 31 Bad debts written off Accounts receivable at end of year 2% of allowance of
December during year (after bad debts written off) doubtful debts

RM RM RM

2014 423 6,000 120

2015 510 7,000 140

2016 604 7,750 155

2017 610 6,500 130

23
Total bad debts written
off from all accounts
receivable

Charged to
Income Statement
 24

2% of (Amount
allowance of increase) Charged
doubtful debts to Income
Statement

(Amount
decrease)
Charged to
Income
Statement
25

Amount
increased

Amount
decreased
26

2% of Ending
balance of
accounts
receivable
The end