Accounting For Bad And Doubtful Debts
Peter Marshall Bsc (Econ) BA MBIM is a Fellow of the Society of Business Teachers, and an experienced educator in business subjects. He is also a prolific author and his books have been translated and sold worldwide. He lives in London, UK.
Not every credit customer (or other debtor) will pay what he owes. He may dispute the amounts; some may disappear or go out of business. The debts they owe to the business may be bad, or of doubtful value. If so, our accounts must reflect the fact.
Accounting for bad and doubtful debts, like depreciation, means estimating an erosion of value. But it differs from depreciation because there it is time that erodes the value. Here it is more a product of fate. We can predict what effect age will have on physical assets like motor cars, but we cannot very easily predict which, and how many, debtors won’t pay their bills. If we could, we should never have given them credit in the first place! There are no special calculation techniques for bad and doubtful debts as there are in depreciation. You just need to choose a suitable overall percentage, and make specific adjustments from time to time in the light of experience.
When a company becomes aware that a debt is uncollectable, because, for example, the customer has been declared bankrupt, or the company has gone into liquidation, the debt is written off by crediting the relevant sales ledger account and debiting bad debts account. Figure 75 provides an example.
We may know a debt has become worthless because the individual has gone bankrupt, or a company has gone into liquidation. Such a debt must then be posted to a ‘bad debts account’. This is an account for specific debts we know to be bad. This is quite aside from our provision for a percentage of debtors control account going bad. If bad debts are recovered later on, we will treat them as credits to bad debts account, and a debit to cash account. We do not need to reopen the individual debtor account, since the posting would result in its immediate closure anyway.
Only if a firm is in liquidation, or if an individual has too few assets to be worth suing, do we need to write off his debt to bad debts account. If the non-payer does have sufficient funds, the firm may be able to sue him successfully for the debt.
Saving tax and being realistic
The reason we need to write down bad or doubtful debts is twofold. First, the firm will be charged income tax on its profits; if the profit figure is shown without allowing for the cost of bad and doubtful debts it will be higher than it should rightly be, and the firm will end up paying more tax than it needs to.
Secondly, the balance sheet should show as realistically as possible the value of the assets of the business. After all, interested parties such as bankers, investors and suppliers will rely on it when making decisions about the firm. Failure to write off bad debts, and too little provision for doubtful debts, will mean an unrealistically high current asset of debtors being shown. Accountants are guided by the principle of prudence. This provides that a) losses should be provided for as soon as anticipated and b) it is preferable to understate profit than overstate it.
1. Suppose A. Frazer received information on 30 August that H. Baker, a customer who owed the firm £200, had been declared bankrupt; the appropriate entries in the books would be as shown in Figure 76.
2. Suppose that A. Frazer estimates his necessary bad debts provision for the year ending 31 March as £600; the book-keeping entries would be as shown in Figure 77.