IGCSE Accounting (0452) Study Notes: Irrecoverable Debts and Provision for Doubtful Debts
Hello future accountant! This chapter covers one of the most common and crucial adjustments businesses need to make at the end of the year. When a business sells goods on credit, there is always a risk that some customers might fail to pay. This risk needs to be recorded accurately to follow the core accounting principles.
Don't worry if this seems tricky at first. We will break down how to handle debts that are certain to be lost (irrecoverable debts) and how to estimate future losses (provisions).
Key Section 1: Irrecoverable Debts (Writing Off Debts)
What are Irrecoverable Debts?
An Irrecoverable Debt (often referred to in the past as a 'Bad Debt') is a specific amount owed by a customer (a Trade Receivable) that the business has concluded will never be collected. The debtor might have gone bankrupt, disappeared, or refused to pay after all legal efforts.
- Key Concept: When a debt becomes irrecoverable, it is treated as a loss or an expense for the business in the period the loss is confirmed.
- Analogy: Imagine selling a friend a valuable item on credit, and they move country and stop communicating. You have to accept that money is gone—it’s an expense of doing business.
Accounting for Irrecoverable Debts (The Write-Off)
When a debt is confirmed as irrecoverable, we must remove it from the books so that the assets (Trade Receivables) are not overstated.
Step 1: The Journal Entry
The irrecoverable debt is an expense, so we debit the expense account and credit the asset account (Trade Receivables).
Double Entry Rule:
- Debit (DR): Irrecoverable Debts Account (This increases the expense).
- Credit (CR): Individual Debtor's Account (in the Sales Ledger) / Trade Receivables Control Account (This reduces the asset).
Example: Mr. A owes \$200 and is declared bankrupt.
| Date | Details | DR (\$) | CR (\$) | |:---|:---|:---|:---| | X | Irrecoverable Debts | 200 | | | | Mr. A (Trade Receivable) | | 200 | | | (To write off the debt owed by Mr. A) | | |
Step 2: Ledger Accounts
The balance of the Irrecoverable Debts Account (which is an expense account) is then transferred to the Income Statement (Profit/Loss Account) at the end of the period.
Quick Review: Irrecoverable Debts are definite losses. They are recorded as an expense immediately and reduce the asset balance.
Key Section 2: Recovery of Debts Written Off
What is Debt Recovery?
Occasionally, a pleasant surprise occurs: a customer whose debt was previously written off pays all or part of the amount owed! This amount is now treated as Income for the current period, not a reduction of the prior expense.
Step 1: Reinstating the Debtor (Optional, but good practice)
Technically, the debt needs to be restored before being paid off. We reverse the write-off journal entry, but usually, we credit an Income account instead of the old Irrecoverable Debts expense account.
Step 2: Recording the Receipt
The actual cash received is recorded:
Double Entry Rule:
- Debit (DR): Cash or Bank Account (Asset increases).
- Credit (CR): Irrecoverable Debts Recovered Account (Income increases).
Example: Mr. A, whose \$200 debt was written off last year, sends a cheque for \$50.
Journal Entry:
| Date | Details | DR (\$) | CR (\$) |
|:---|:---|:---|:---|
| Y | Bank | 50 | |
| | Irrecoverable Debts Recovered | | 50 |
| | (Receipt of previously written-off debt) | | |
The balance of the Irrecoverable Debts Recovered Account is transferred to the Income Statement as other income.
Key Section 3: Provision for Doubtful Debts
Why Do We Need a Provision?
Even if you haven't written off a specific debt yet, accounting rules require you to anticipate losses to present a true and fair view of the business.
A Provision for Doubtful Debts is an estimate of the total amount of Trade Receivables that may become irrecoverable in the future. It is based on past experience or current economic conditions.
This follows two important accounting principles:
- The Prudence Concept: We should not overstate assets (Trade Receivables) or profits. We anticipate future losses but do not anticipate future gains.
- The Matching Concept: If the sales were made in Year 1, any expected loss from those sales must also be matched (recorded) in the Income Statement for Year 1.
Provision vs. Irrecoverable Debt
This is a common point of confusion!
- Irrecoverable Debt: Certain loss. Written off against the individual debtor’s account.
- Provision for Doubtful Debts: Estimated loss. Created against the total Trade Receivables balance (a deduction in the Statement of Financial Position). No individual debtor's account is affected.
Recording the Provision
The provision itself is a contra-asset account—it reduces the value of Trade Receivables in the Statement of Financial Position (SOFP).
We do not debit Trade Receivables directly; instead, we create a Provision account.
The Double Entry for CREATION or INCREASE in Provision:
If the provision needs to be created for the first time or if the required balance is higher than last year:
- Debit (DR): Income Statement (as an expense).
- Credit (CR): Provision for Doubtful Debts Account (as a deduction from assets).
This amount represents the increase in the provision for the year.
The Double Entry for DECREASE in Provision:
If the required balance is lower than last year, we reduce the Provision account. This reduction acts as income because the estimated loss was too high.
- Debit (DR): Provision for Doubtful Debts Account.
- Credit (CR): Income Statement (as income/gain).
Memory Aid: Think of the Provision account as a safety net.
DR P/L - When the net needs to be made bigger (Loss/Expense)
CR P/L - When the net can be made smaller (Gain/Income)
Step-by-Step: Adjusting the Provision
To find the entry needed for the Income Statement, you must calculate the change in the provision, not the final balance.
Example Scenario:
- At the start of Year 2, Provision balance was \$500.
- At the end of Year 2, Trade Receivables are \$10,000. Management estimates a 6% provision is needed.
Calculation:
Required Provision (New Balance) = 6% of \$10,000 = \$600
Existing Provision (Old Balance) = \$500
Required Increase (Expense) = \$600 - \$500 = \$100
Journal Entry for the Increase (\$100):
| Date | Details | DR (\$) | CR (\$) | |:---|:---|:---|:---| | Year 2 | Income Statement | 100 | | | | Provision for Doubtful Debts | | 100 | | | (Increase provision from \$500 to \$600) | | |
Scenario 2: Provision Decrease
- At the start of Year 3, Provision balance was \$600.
- At the end of Year 3, required provision is calculated to be \$450.
Calculation:
Required Decrease (Income) = \$600 - \$450 = \$150
Journal Entry for the Decrease (\$150):
| Date | Details | DR (\$) | CR (\$) | |:---|:---|:---|:---| | Year 3 | Provision for Doubtful Debts | 150 | | | | Income Statement | | 150 | | | (Decrease provision from \$600 to \$450) | | |
Where Do These Items Go in the Financial Statements?
Income Statement (Profit/Loss Account):
- Irrecoverable Debts Written Off (Section 1) are shown as an Expense.
- Change in Provision (Section 3):
- Increase in Provision is shown as an Expense.
- Decrease in Provision is shown as Income (or a negative expense).
- Irrecoverable Debts Recovered (Section 2) are shown as Other Income.
Statement of Financial Position (SOFP):
The Provision affects the calculation of current assets.
Current Assets:
Trade Receivables (Gross amount)
Less: Provision for Doubtful Debts (Closing Balance)
Net Trade Receivables
Did you know? The net figure (Net Trade Receivables) is the amount management realistically expects to collect. This is a crucial number for anyone analyzing the liquidity of the business.
Common Mistakes to Avoid
1. Writing Off Debt vs. Provision:
Do NOT write off a specific customer's debt against the Provision for Doubtful Debts account. Irrecoverable Debts are written off against the Trade Receivables account (or Sales Ledger) first.
2. Focusing on the Change:
Remember, the Income Statement is only interested in the CHANGE in the Provision. The SOFP uses the FINAL CLOSING BALANCE of the Provision.
3. Debit vs. Credit Confusion:
If the Provision increases, the change is an Expense (DR Income Statement). If the Provision decreases, the change is Income (CR Income Statement).
Quick Review Box
Irrecoverable Debts: Definite Loss. DR Expense, CR Trade Receivables.
Provision for Doubtful Debts (PPDD): Estimated Loss.
PPDD Increase: DR Income Statement (Expense).
PPDD Decrease: CR Income Statement (Income).
SOFP: Trade Receivables shown Net of the PPDD Closing Balance.