Selling on credit increases sales, but some customers will not pay. It would mislead users to keep showing amounts as receivables when there is little or no chance of collecting them. So the business writes off the debts it believes are lost, and sets up an allowance for the ones it doubts.
This topic covers how to write off a bad debt, how to record a recovery, how to measure and move the allowance for doubtful debts, how the two combine in the statements, and how an aged analysis helps.
Bad and doubtful debts feature in nearly every set of final accounts, and appeared as a question or a large part of one in 3 of the 20 diets, with a Section A item in about half of them. Read the topic on accounting concepts, where prudence is explained, and the topic on receivables control accounts. The next topic covers accrued expenses and accrued income.
In 30 seconds
A Bad debt is owed by a customer the business believes will never pay. It is Written off: Dr Bad and doubtful debts expense, Cr Receivables. A Doubtful debt might be hard to collect but the business still hopes to collect. It stays in the records and an Allowance (always a credit balance) is set against it: Dr Bad and doubtful debts expense, Cr Allowance.
Only the Movement in the allowance goes through the expense. The annual charge is Bad debts written off plus the increase, or less the decrease, in the allowance. In the statement of financial position, receivables are shown net of bad debts written off and of the allowance. Prudence requires that assets are not shown above the cash they will produce.
Bad debts and doubtful debts
If competitors offer credit, a business has little choice but to do so too, and credit usually raises sales. The risk is that some customers fall into difficulty. Prudence requires an adjustment for receivables the business thinks it will not recover. A business should not show an asset at more than the cash it will generate. There are two categories.
| Category | Meaning | Examples |
|---|---|---|
| Bad debt (irrecoverable debt) | An amount the business believes it will never collect | Bankruptcy or insolvency of the customer; death of a customer who left too little to pay; a dispute over whether the contract was fulfilled; dishonesty, where goods were obtained with no intention to pay |
| Doubtful debt | An amount that may prove difficult to collect, but the business still hopes to collect | A customer with cash flow problems; one taking unusually long to pay; one with operating difficulties, such as strikes or a disaster that disrupted production |
They are accounted for differently, although a business often has a single bad and doubtful debts expense account.
Writing off and recovering bad debts
When a specific debt is considered bad, it is Written off, which means it is removed from the accounting system and supporting records. The entries are Dr Bad and doubtful debts expense, Cr Receivables control account, with the customer’s account in the receivables ledger credited and reduced to nil. Total receivables fall, which reduces assets, and the expense reduces profit and so capital.
At the year end the expense is transferred to the statement of profit or loss. For example, a business with receivables of ₦750,000 writes off ₦15,000. The control account closes at ₦735,000 and the expense account shows ₦15,000, which is transferred to profit or loss.
Occasionally cash is received for a debt written off in an earlier period. The entry is Dr Bank, Cr Bad debts recovered. The credit reduces the bad debt expense in the statement of profit or loss, which recognises that an expense was recorded when, with hindsight, it need not have been.
Background: some examiners prefer the longer form, which first reinstates the debt, Dr Receivables and Cr Bad debts recovered, and then records the cash, Dr Bank and Cr Receivables. It gives the same result and keeps the customer’s history in the ledger.
The allowance for doubtful debts
For a doubtful debt the business has two aims. Prudence requires that the receivable is reduced, perhaps to nil, and an expense recognised. But the receivable must stay in the records so that the business keeps chasing payment. The answer is an allowance for doubtful debts, also called a provision.
The entry is Dr Bad and doubtful debts expense, Cr Allowance for doubtful debts, with no entry in the receivables ledger. The allowance is a credit balance, set against receivables in the statement of financial position, as follows.
| Statement of financial position | ₦ |
|---|---|
| Trade receivables (net of bad debts written off) | X |
| Less: allowance for doubtful debts | (X) |
| Figure shown for trade receivables | X |
The difference from a write-off is that when an allowance is created, total receivables are Not reduced. The allowance sits in its own account.
Measuring the allowance
An allowance is recognised only if the business knows the customer might not pay. When it knows of particular customers in difficulty, it sets up a Specific allowance for them. A business with many customers also knows from experience that some will fail at each year end without knowing which. It may then add a General allowance, but it must justify the amount from verifiable experience.
It cannot choose one as it pleases. The general allowance is a percentage of the remaining receivables, after taking out those that carry a specific allowance.
The movement on the allowance
A business keeps an allowance balance at each year end, so the expense recognised is only the Movement. If the allowance rises, the increase is an expense: Dr Expense, Cr Allowance. If it falls, the decrease is a credit to the expense: Dr Allowance, Cr Expense. Take receivables of ₦1,000,000, ₦1,200,000 and ₦900,000 and an allowance of 2% each year: ₦20,000, ₦24,000 and ₦18,000.
The year 1 charge is ₦20,000, the year 2 charge is the increase of ₦4,000, and in year 3 the allowance falls by ₦6,000, a credit to the expense.
Bad and doubtful debts together
Any question will involve both. The charge in the statement of profit or loss for the year is:
Bad debts written off + increase in allowance (or − decrease in allowance)
For example, trade receivables of ₦75,000 include a bad debt of ₦5,000, and a first allowance of ₦2,000 is created. Receivables fall to ₦70,000 and the expense is ₦5,000 + ₦2,000 = ₦7,000. In year 2, with credit sales of ₦200,000, receipts of ₦185,000 and bad debts of ₦8,000, receivables close at ₦77,000. The allowance falls from ₦2,000 to ₦1,500, so the expense is ₦8,000 − ₦500 = ₦7,500, and the statement of financial position shows ₦77,000 − ₦1,500 = ₦75,500.
The balance on the receivables account is reduced by bad debts written off but not by the allowance.
Doubtful debts recovered
Cash from a customer against whom an allowance was set is recorded like any other receipt: Dr Bank, Cr Receivables. No special entry is needed. The credit to profit or loss happens automatically when the allowance is re-estimated at the year end, because the amount recovered is no longer in the allowance, so the allowance falls and the expense is reduced.
For example, an opening allowance of ₦8,000 (customer A ₦6,000 and customer B ₦2,000) falls to ₦6,000 when B pays in full, and the reduction of ₦2,000 is a credit to the expense.
Aged receivables analysis
An aged receivables analysis lists for each customer the total owed, split by how long each invoice has been outstanding, for example under 30 days, 30 to 60, 60 to 90 and over 90 days. It helps judge which debts may turn bad. Old balances should be investigated and collection attempted.
The investigation may show that the debt should be written off, or that an allowance should be made, meaning the debt is not written off yet but its chances of payment look doubtful.
The ideas in more depth
Write-off or allowance. A write-off removes the debt and ends the chase. An allowance keeps it. The allowance is a credit. It is never an expense account balance and it is never debited at the start of a year. Only the movement counts. The closing allowance is the figure that must be right, and the entry is the difference from the opening balance.
Specific before general. Take out the specific debts before applying the general percentage. Bad debts recovered. A recovery of a debt written off earlier is income. A recovery of a doubtful debt needs no special entry.
Worked example: Nnewi Traders
Scenario. At the year end trade receivables are ₦900,000 before writing off a bad debt of ₦30,000 owed by Dike. Eze owes ₦24,000 and is in difficulty, so a specific allowance covers all of it. A general allowance of 4% applies to the other receivables. The opening allowance was ₦45,000. A debt of ₦5,000 written off last year was recovered in cash this year.
Required: the charge to profit or loss and the statement of financial position extract.
- Receivables after the write-off.
900,000 − 30,000 = 870,000. - Specific allowance. Eze 24,000.
- General allowance.
(870,000 − 24,000) × 4% = 846,000 × 4% = 33,840. - Total allowance.
24,000 + 33,840 = 57,840. - Movement.
57,840 − 45,000 = increase of 12,840. - Charge.
Bad debts 30,000 + increase 12,840 = 42,840, less the recovery of 5,000 = ₦37,840. - Entries. Dr Bad debts 30,000, Cr Receivables 30,000. Dr Expense 12,840, Cr Allowance 12,840. Dr Bank 5,000, Cr Bad debts recovered 5,000.
- Statement of financial position. Trade receivables 870,000, less allowance 57,840, gives ₦812,160.
Common mistakes in the exam
- Charging the whole closing allowance to the expense instead of only the movement.
- Reducing receivables by the allowance in the ledger. The allowance is a separate credit account.
- Applying the general percentage to the full receivables instead of the amount left after the specific debts.
- Calculating the allowance before deducting the bad debts written off.
- Treating a fall in the allowance as an expense. It is a credit to the expense.
- Making a special entry for a doubtful debt recovered.
- Forgetting the recovery of bad debts as a credit to profit or loss.
Quick revision
- Write off: Dr Bad debts expense, Cr Receivables. Recovery of a written-off debt: Dr Bank, Cr Bad debts recovered.
- Allowance: Dr Expense, Cr Allowance. It is always a credit balance.
- Charge = bad debts + increase in allowance (or − decrease). General allowance on receivables after specific debts.
- SOFP: receivables net of bad debts written off, less the allowance.
- Doubtful debt recovered: Dr Bank, Cr Receivables only.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one first.
Section A style: multiple choice
Question 1. Writing off a bad debt of ₦20,000 is recorded as:
- Dr Receivables, Cr Bad debts
- Dr Bad debts, Cr Receivables
- Dr Allowance, Cr Receivables
- Dr Bank, Cr Bad debts
Show the answer
B. A bad debt is an expense. Debit bad debts and credit receivables to remove the debt.
Question 2. An increase in the allowance for doubtful debts is recorded as:
- Dr Allowance, Cr Expense
- Dr Expense, Cr Allowance
- Dr Receivables, Cr Allowance
- Dr Bank, Cr Allowance
Show the answer
B. An increase in the allowance is an expense: debit the expense and credit the allowance.
Question 3. The allowance for doubtful debts has a:
- Credit balance
- Debit balance
- Nil balance always
- Debit in year 1 only
Show the answer
A. It is set against receivables.
Question 4. Receivables are ₦400,000, the allowance is 5% and the existing allowance is ₦15,000. The charge for the allowance is:
- ₦15,000
- ₦20,000
- ₦5,000
- ₦35,000
Show the answer
C. 5% × 400,000 = 20,000, an increase of 5,000.
Question 5. The allowance falls from ₦24,000 to ₦18,000. The entry is:
- Dr Expense ₦6,000, Cr Allowance ₦6,000
- Dr Allowance ₦18,000, Cr Expense
- Dr Allowance ₦6,000, Cr Expense ₦6,000
- No entry
Show the answer
C. It reduces the expense.
Question 6. Cash of ₦9,000 is received for a debt written off last year. The entry is:
- Dr Bank, Cr Receivables only
- Dr Bad debts, Cr Bank
- No entry
- Dr Bank, Cr Bad debts recovered
Show the answer
D. The debt is recovered, so debit bank and credit bad debts recovered.
Question 7. Cash is received from a customer against whom an allowance was set. The entry is:
- Dr Bank, Cr Bad debts recovered
- Dr Allowance, Cr Bank
- Dr Bank, Cr Receivables
- Dr Bank, Cr Allowance
Show the answer
C. The allowance is adjusted at the year end.
Question 8. Receivables are shown in the statement of financial position:
- Net of bad debts written off and less the allowance
- At gross sales
- Including the allowance
- Without deducting anything
Show the answer
A. Receivables are shown after bad debts written off and net of the allowance.
Question 9. Prudence means an asset is not shown at more than:
- Its original cost
- Its replacement cost
- The owner’s estimate
- The cash it will generate
Show the answer
D. Under prudence an asset is not carried at more than the cash it is expected to generate.
Question 10. A general allowance must be based on:
- The owner’s preference
- A round figure
- Last year’s sales
- Verifiable experience
Show the answer
D. A general allowance must rest on verifiable experience, such as past loss rates.
Section B style: written questions
Question 11 (10 marks). (a) Distinguish a bad debt from a doubtful debt, with one circumstance for each. (4 marks) (b) Give the entries to write off ₦25,000 and to record ₦9,000 recovered from a debt written off last year. (4 marks) (c) Explain why a doubtful debt is not written off. (2 marks)
Question 12 (20 marks). Receivables at the start of year 1 were ₦500,000. In year 1 credit sales were ₦2,600,000, cash received ₦2,450,000 and bad debts written off ₦40,000. The allowance at the end is 5% of closing receivables. In year 2 credit sales were ₦3,000,000, cash received ₦2,900,000 and bad debts ₦52,000, and the allowance is 4% of closing receivables. There was no allowance at the start of year 1.
(a) Prepare the receivables control account for both years. (6 marks) (b) Prepare the allowance account for both years. (5 marks) (c) Prepare the bad and doubtful debts expense account. (5 marks) (d) Show the statement of financial position extracts. (4 marks)
A further written question
Question 13 (10 marks). The opening allowance is ₦36,400. Closing receivables are ₦640,000 after writing off ₦12,000, and the allowance is to be 5%. (a) Calculate the charge to profit or loss. (5 marks) (b) Show the statement of financial position extract. (3 marks) (c) State the effect on profit of a reduction in the allowance. (2 marks)
Model answers
Show the model answer to Question 11
(a) A bad debt is owed by a customer the business believes will never pay, for example a customer declared insolvent. A doubtful debt might be hard to collect but the business still hopes to, for example a customer with cash flow problems. (b) Write off: Dr Bad debts 25,000, Cr Receivables 25,000. Recovery: Dr Bank 9,000, Cr Bad debts recovered 9,000.
(c) It stays in the records so the business continues to chase payment, and an allowance reduces the carrying amount for prudence.
Show the model answer to Question 12
(a) Receivables.
- Year 1: 500,000 + 2,600,000 − 2,450,000 − 40,000 = 610,000.
- Year 2: 610,000 + 3,000,000 − 2,900,000 − 52,000 = 658,000.
(b) Allowance.
- Year 1: 5% × 610,000 = 30,500, an increase of 30,500.
- Year 2: 4% × 658,000 = 26,320, a decrease of 4,180.
(c) Expense.
- Year 1: 40,000 + 30,500 = 70,500.
- Year 2: 52,000 − 4,180 = 47,820.
(d) SOFP.
- Year 1: 610,000 − 30,500 = 579,500.
- Year 2: 658,000 − 26,320 = 631,680.
Show the model answer to Question 13
(a)
- Allowance 5% × 640,000 = 32,000.
- Movement.
36,400 − 32,000 = a decrease of 4,400. - Charge = bad debts 12,000 − 4,400 = ₦7,600.
(b) Trade receivables 640,000, less allowance 32,000 = ₦608,000.
(c) A reduction in the allowance is a credit to the expense, so it increases profit.
Pathfinder on Bad debts and the allowance for doubtful debts
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. A company starts with receivables of ₦1,564,000 and an allowance of ₦78,200. Asks for the entries for bad debts and the allowance. Part (b) prepares a sole trader’s statements.
Revise first: Bad and doubtful debts together
From the previous syllabus. Asks for the receivables and bad debt entries of a company from its opening receivables, credit sales, receipts and bad debts written off.
Revise first: Bad and doubtful debts together
Asks you to post and balance the trade receivables account (8 marks), the bad debts account (3 marks) and the allowance account (6 marks), and to extract the statement of financial position at each year end (3 marks), for a company with a customer unable to pay in full.
Revise first: The allowance for doubtful debts
Asks to which account the bad debts account is closed in preparing the statements.
Revise first: Writing off and recovering bad debts
From the previous syllabus. Asks for the allowance written back when it is adjusted to 5% of receivables after a bad debt is written off.
Revise first: Bad and doubtful debts together
From the previous syllabus. Both ask for the effect of a reduction in the allowance for doubtful debts.
Revise first: The allowance for doubtful debts
From the previous syllabus. These ask for the charge or allowance in the statement of profit or loss from receivables figures and a percentage.
Revise first: Bad and doubtful debts together
Question 3 of May 2024 asks which statement differentiates bad debt from doubtful debt. Question 3 of November 2023 asks for the general allowance in the statement of profit or loss.
Revise first: Bad debts and doubtful debts
One item a diet usually asks for the allowance, the charge to profit or loss, or the effect of changing the allowance. Check Section A of every diet you practise.
Revise first: Bad and doubtful debts together
Source: ICAN Pathfinder, Financial Accounting. Diets covered: November Diet, 2014, May Diet, 2015, May Diet, 2016, November Diet, 2016, May Diet, 2017, November Diet, 2018, May Diet, 2021, May Diet, 2022, May Diet, 2023, November Diet, 2023 and May Diet, 2024. Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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