make adjustments for irrecoverable debts and provisions for doubtful debts
Cambridge IGCSE Accounting (0452) – Adjustments for Irrecoverable Debts & Provisions for Doubtful Debts
1. Fundamentals of Accounting (Syllabus Unit 1)
- Purpose of accounting: record, classify and interpret financial information to help users make decisions.
- Book‑keeping vs. accounting:
- Book‑keeping – the systematic recording of transactions in journals and ledgers.
- Accounting – the wider process that includes interpreting, analysing and communicating the information recorded.
- Accounting equation: Assets = Liabilities + Owner’s Equity.
- Double‑entry system: every transaction affects at least two accounts – one debit and one credit.
- Profit‑and‑loss measurement: Revenue – Expenses = Profit (or Loss) for the period.
2. Sources & Recording of Data (Syllabus Unit 2)
2.1 Key business documents that generate accounting entries
| Document | Typical entry (debit / credit) |
|---|---|
| Sales invoice | Trade receivables / Sales revenue |
| Purchase invoice | Trade payables / Purchases |
| Credit note (bad‑debt write‑off) | Bad‑debt expense / Trade receivables |
| Debit note (return to supplier) | Trade payables / Purchases returns |
| Cash receipt (bank slip) | Bank / Trade receivables or Sales revenue |
| Cheque / paying‑in slip | Bank / Cash payments |
| Bank statement | Bank / Various accounts (reconciliation) |
| Petty‑cash imprest voucher | Petty‑cash / Cash |
| Electronic funds transfer (EFT) / direct debit | Bank / Trade payables or Receivables |
2.2 Books of prime entry (journals)
- Sales journal – records credit sales and sales returns.
- Purchases journal – records credit purchases and purchase returns.
- Cash book – records all cash receipts and payments (both cash and bank columns).
- Petty‑cash (imprest) book – records small cash outlays and replenishments.
- General journal – records non‑regular or adjusting transactions (e.g., bad‑debt write‑offs, provisions, depreciation).
- Sales‑returns & Purchases‑returns journals – sometimes kept as separate subsidiary journals.
2.3 Ledgers and posting (Syllabus Unit 3)
- Sales ledger (debtor ledger) – individual customer accounts.
- Purchases ledger (creditor ledger) – individual supplier accounts.
- Nominal (general) ledger – all expense, income, asset, liability and equity accounts.
- Post each journal entry to the appropriate ledger accounts, total the debit and credit sides, and prepare a trial balance to check that total debits = total credits.
- Include trade and cash discounts where applicable (e.g., 2 % discount on early payment).
3. Verification of Records (Syllabus Unit 3)
- Common error types: omission, commission, principle, transposition, reversal.
- If an error is discovered after the trial balance, correct it with a journal entry (e.g., “Commission error – debit/credit the correct accounts”).
- Re‑prepare the trial balance after corrections to ensure it remains balanced.
4. Adjustments – Irrecoverable Debts & Provisions (Syllabus Unit 4)
4.1 Irrecoverable (Bad) Debts
- Definition: amounts owed by customers that are deemed impossible to collect (e.g., bankruptcy, loss of trace).
- Treatment: write‑off directly against an expense account – Bad Debt Expense.
4.1.1 Journal entry – write‑off a specific bad debt
Debit Bad Debt Expense .......... $X
Credit Trade Receivables .......... $X
(To write off an irrecoverable debt)
4.1.2 Effect on the financial statements
- Balance sheet: Trade receivables reduced.
- Profit‑and‑loss account: Bad‑debt expense increases, reducing profit.
4.2 Provisions for Doubtful Debts
- A contra‑asset account that estimates the amount of receivables likely to become bad in the future.
- Receivables are shown at their net realizable value (gross receivables – provision).
- Based on the matching principle – the expense is recognised in the same period as the related revenue.
4.2.1 Methods of estimating the provision
- Percentage of trade receivables – apply a single rate (e.g., 2 %) to the total gross receivables.
- Aging schedule – group receivables by age (0‑30, 31‑60, 61‑90, >90 days) and apply different percentages to each group.
4.2.2 Calculating the required provision
Required provision P = Σ (amount in each age‑group × appropriate %).
4.2.3 Adjusting entry
If the existing provision balance is E (credit) and the required provision is P, the adjustment is Δ = P – E:
Debit Bad Debt Expense .......... $Δ
Credit Provision for Doubtful Debts .......... $Δ
(To adjust the provision to the required amount)
4.2.4 Reversal when a doubtful debt is actually collected
Debit Bank .......... $X
Credit Trade Receivables .......... $X
(Cash receipt)
Debit Provision for Doubtful Debts .......... $X
Credit Bad Debt Expense .......... $X
(Reverse the portion of the provision used)
5. Preparation of Financial Statements (Syllabus Unit 5)
5.1 Income Statement (Profit & Loss Account)
| Revenue & Gains | Amount ($) |
|---|---|
| Sales | … |
| Other income | … |
| Total revenue | … |
| Cost of goods sold | … |
| Gross profit | … |
| Operating expenses (incl. Bad‑debt expense & provision adjustment) | … |
| Net profit | … |
5.2 Statement of Financial Position (Balance Sheet)
| Assets | Amount ($) |
|---|---|
| Trade receivables (gross) | … |
| Provision for doubtful debts (contra‑asset) | (…) |
| Trade receivables (net) | … |
| Cash & bank | … |
| Other assets | … |
| Total assets | … |
| Liabilities & Owner’s Equity | Amount ($) |
| Trade payables | … |
| Accruals / pre‑payments | … |
| Owner’s capital (opening) | … |
| Add: Net profit for the year | … |
| Less: Drawings | … |
| Owner’s capital (closing) | … |
| Total liabilities & equity | … |
6. Worked Example – Year‑End Adjustment for Bad Debts & Provision
6.1 Given information
- Trade receivables (gross) at 31 December: $45,000
- Specific bad debts identified: $2,500
- Management policy: 3 % provision on net receivables after writing off bad debts.
- Existing provision for doubtful debts (credit balance): $800
6.2 Step‑by‑step solution
- Write‑off specific bad debts
Debit Bad Debt Expense .......... $2,500 Credit Trade Receivables .......... $2,500 - Calculate net receivables after write‑off
Net receivables = $45,000 – $2,500 = $42,500
- Determine required provision (3 % of net receivables)
P = 0.03 × $42,500 = $1,275
- Compute adjustment needed
Existing provision E = $800 (credit) Δ = P – E = $1,275 – $800 = $475
- Record the adjusting entry for the provision
Debit Bad Debt Expense .......... $475 Credit Provision for Doubtful Debts .......... $475
6.3 Adjusted trial balance (excerpt)
| Account | Debit ($) | Credit ($) |
|---|---|---|
| Trade Receivables (gross) | 45,000 | |
| Provision for Doubtful Debts | 1,275 | |
| Bad Debt Expense | 2,975 | |
| Sales Revenue | … | |
| Other expenses | … | |
| Owner’s Capital (opening) | … | |
| Total debits = total credits (balanced) | ||
7. Analysis, Interpretation & Ratios (Syllabus Unit 6)
- Profitability: Bad‑debt expense reduces net profit, which in turn lowers the closing capital.
- Asset valuation: Net realizable value of trade receivables is more realistic, giving a clearer picture of liquidity.
- Key ratios:
- Receivables turnover = Credit sales ÷ Average net receivables.
- Days sales outstanding (DSO) = 365 ÷ Receivables turnover.
- Profit margin = Net profit ÷ Sales revenue (both reduced by bad‑debt expense).
8. Accounting Principles & Policies (Syllabus Unit 7)
- Matching principle: Expenses (bad‑debt expense & provision) are recorded in the same period as the related revenue.
- Prudence (conservatism): Anticipate probable losses (provision) but not gains.
- Consistency: Use the same method of estimating the provision each year unless a justified change is made.
- Full disclosure: State the method of estimating doubtful debts and the amount of the provision in the notes to the accounts.
9. Quick Revision Checklist (Paper 1 & Paper 2)
- Know the journal entry to write‑off a specific bad debt.
- Be able to calculate a provision using both the percentage‑of‑receivables and aging‑schedule methods.
- Remember the adjusting‑entry formula: Δ = Required provision – Existing provision.
- Show the impact of the adjustments on the income statement and balance sheet.
- Explain how the provision is a contra‑asset and why it is required under prudence.
- Recall the effect on key ratios (receivables turnover, DSO, profit margin).
- Apply the matching and prudence principles when answering structured (Paper 2) questions.
- For multiple‑choice (Paper 1) remember the definitions of “bad debt”, “provision”, “contra‑asset” and the direction of debit/credit for each entry.
10. Suggested Diagram – Flowchart of Year‑End Adjustment Process
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