explain the reasons for maintaining a provision for doubtful debts

4.4 Irrecoverable Debts and Provision for Doubtful Debts

Objective

Explain why a provision for doubtful debts is required, demonstrate how to calculate the provision, and show the journal entries for creating, adjusting, writing‑off and recovering debts. Relate each step to the relevant accounting principles in the Cambridge IGCSE/A‑Level syllabus.

1. What are Doubtful (Irrecoverable) Debts?

• Trade receivables (debtors) – amounts owed by customers for credit sales.
• Doubtful/irrecoverable debts – the portion of trade receivables that the business expects will not be collected.
• When a debt is judged irrecoverable it is written‑off; if the amount is later received the entry is reversed.

Ledger illustration (write‑off and later recovery)

2. Why a Provision for Doubtful Debts is Required

Maintaining a provision satisfies a number of accounting concepts required by the Cambridge syllabus:

1. True and fair view – the balance sheet reports the amount of receivables that the business actually expects to collect.
2. Matching (expense‑recognition) principle – the estimated bad‑debt expense is recognised in the same period as the credit sales that created the receivable, ensuring that revenue and related expense are matched.
3. Prudence (conservatism) – probable losses are recorded as soon as they are identified, preventing an over‑statement of assets.
4. Business‑entity principle – the provision keeps the owner’s equity separate from the assets of the business by recognising a liability (contra‑asset) for expected losses.
5. Going‑concern assumption – assets are measured at the amount expected to be realised in the normal course of business; doubtful debts are therefore shown at their recoverable amount.
6. Compliance with standards – IAS 1, IAS 9 (and the IGCSE Accounting syllabus) require assets to be stated at recoverable value.
7. Decision‑making support – realistic receivable figures aid credit‑policy review, cash‑flow forecasting and working‑capital planning.

3. Methods for Calculating the Provision

3.1 Percentage of Receivables Method

Apply a single percentage (derived from past experience) to the total trade receivables.

Worked example

Journal entry to create the provision:

Debit   Bad Debts Expense........£1,120
    Credit   Provision for Doubtful Debts........£1,120

3.2 Ageing (Bracket) Method

Group debts by the length of time they have been outstanding and apply a different percentage to each group.

3.3 Comparison of the Two Methods

4. Journal Entries

4.1 Creating the provision (year‑end)

Debit   Bad Debts Expense..................£1,110
    Credit   Provision for Doubtful Debts........£1,110

4.2 Adjusting the provision

If the existing balance in the provision account is £800 and the calculation shows £1,110 is required:

Debit   Bad Debts Expense..................£310
    Credit   Provision for Doubtful Debts........£310

If the existing balance is £1,500 and only £1,110 is needed:

Debit   Provision for Doubtful Debts......£390
    Credit   Bad Debts Expense..................£390

4.3 Writing‑off a specific debt

• When a provision already exists for that debt:

Debit   Provision for Doubtful Debts......£X
    Credit   Trade Receivables..................£X

• When no provision exists (or the amount is not covered):

Debit   Bad Debts Expense..................£X
    Credit   Trade Receivables..................£X

4.4 Recovering a debt that was previously written‑off

Debit   Trade Receivables..................£X
    Credit   Provision for Doubtful Debts......£X

5. Impact on the Financial Statements

• Income statement (Profit & Loss) – Bad‑debts expense reduces profit for the period in which the provision is created or adjusted.
• Balance sheet – Trade receivables are shown at Net Realisable Value (NRV):
  NRV = Trade Receivables – Provision for Doubtful Debts
• Statement of cash flows – Bad‑debts expense is a non‑cash charge; it is added back to profit in the operating activities section.

6. Summary of Reasons for Maintaining a Provision

1. Provides a realistic estimate of cash that will actually be received.
2. Ensures the expense is matched with the revenue that created the receivable.
3. Applies the prudence, business‑entity and going‑concern principles, avoiding an over‑statement of assets.
4. Meets statutory and accounting‑standard requirements (IAS 1, IAS 9, Cambridge IGCSE syllabus).
5. Supports better credit‑control decisions, cash‑flow forecasting and working‑capital planning.