understand the meaning of irrecoverable debts and recovery of debts written off

Effect on the accounts

• No additional expense is recorded – the expense was recognised when the provision was created.
• Trade receivables fall, and the contra‑asset provision falls by the same amount, leaving equity unchanged.

4. Provision for doubtful debts (AO2)

The provision is an estimate of the amount of trade receivables that may become irrecoverable in the next accounting period. It is reviewed and adjusted at each year‑end.

4.1 How the provision is calculated – typical percentage method

Example (service business):

• Closing trade receivables at 31 May: £12 000
• Company policy: 5 % of closing receivables are expected to be doubtful.
• Required provision = 5 % × £12 000 = £600

If the existing provision balance is £400, the additional amount needed is £200.

Effect on the accounts

• Bad Debts Expense reduces profit for the period.
• The provision (contra‑asset) increases, reducing the net amount of trade receivables shown on the balance sheet.
• Retained earnings fall by the amount of the expense.

4.2 Quick example – manufacturing firm

ABC Manufacturing reports trade receivables of £5 000 at year‑end. Its policy is to provision 10 % of doubtful debts.

• Required provision = 10 % × £5 000 = £500.
• If the existing provision is £300, an additional £200 is required (same journal entry as above).

This shows that the same accounting treatment applies regardless of the type of business.

5. Recovery of a debt previously written off

5.1 Recovery when no provision was used (direct write‑off)

Two journal entries are required.

1. Re‑establish the receivable (reverse the original expense)

   Account	Debit (£)	Credit (£)
   Trade Receivables	Amount recovered
   Bad Debts Expense		Amount recovered

2. Record the cash receipt

   Account	Debit (£)	Credit (£)
   Cash	Amount recovered
   Trade Receivables		Amount recovered

Effect: The reversal of Bad Debts Expense increases profit (or reduces the loss) for the period in which the recovery is recorded. Cash rises, and the net receivable balance is unchanged because it is cleared immediately.

5.2 Recovery when a provision was used

Only one entry is needed because the provision already holds the credit side of the original write‑off.

Effect: No further impact on profit because the expense was recognised when the provision was created. Cash increases and the provision is reduced by the same amount.

6. Impact on key ratios (AO2 & AO3)

• Current ratio = Current assets ÷ Current liabilities. Writing off a bad debt reduces current assets (trade receivables), so the ratio may fall unless the reduction is offset by a proportional decrease in current liabilities.
• Net profit margin = Net profit ÷ Sales. Bad‑debt expense lowers net profit, therefore the margin falls.
• Accounts‑receivable turnover = Credit sales ÷ Average trade receivables. Removing a doubtful amount reduces the denominator, potentially raising the turnover ratio.

When commenting on financial performance, students should note both the profit impact and the effect on liquidity ratios.

7. Accounting principles involved (AO1)

• Prudence (conservatism) – recognising a probable loss (bad debt) as soon as it is identified.
• Matching – the expense is matched to the period in which the related revenue was earned (via the provision).
• Materiality – only debts that are material to the financial statements are written off or provisioned.

8. Related concepts (link to Syllabus 4.3 – other payables & receivables)

Provisions for doubtful debts are a type of contra‑asset, similar in nature to accrued expenses (a liability) and prepaid expenses (an asset). Understanding the treatment of provisions helps students see the common theme of adjusting entries that bring the trial balance in line with the true financial position.

9. Trial balance check

All journal entries above consist of equal debit and credit amounts, so the total debits and total credits remain equal. A quick check after posting each entry confirms that the trial balance still balances.

10. Command‑word checklist (Paper 2)

11. Summary checklist

1. Identify a debt that is unlikely to be collected.
2. Determine whether a provision for doubtful debts already exists.
   • If yes, write off using the provision.
   • If no, write off directly to Bad Debts Expense.
3. Post the appropriate journal entry(ies) and verify that the trial balance remains balanced.
4. At year‑end, calculate the required provision (e.g., % of closing receivables) and post the adjusting entry.
5. If a previously written‑off debt is later recovered, record the reversal (no‑provision) or the single cash‑vs‑provision entry (with provision).
6. State the effect on profit, retained earnings (equity) and the net amount of trade receivables shown on the balance sheet.
7. Comment on any changes to the current ratio, profit margin or receivables turnover.