ADJUSTMENT TO FINAL ACCOUNTS

BAD DEBTS,PROVISION FOR BAD DEBTS AND CASH DISCOUNTS

PREPARED BY: WARUI MAINA

TREATMENT OF BAD DEBTS

• Bad debts are debts that customers can’t repay either due to insolvency or other circumstances e.g. inflation.

• They are an expense to the business.

• They are recorded as follows:

Dr. Bad debts a/c Cr. Specific debtor’s a/c

• This has the effect of removing the debtor from the books of accounts.

• At the end of the period, the total bad debts are transferred to profit and loss account.

Dr. Profit and loss a/c Cr. Bad debts a/c

ALLOWANCE FOR BAD AND DOUBTFUL DEBTS (UNCOLLECTIBLES)

• After bad debts are deducted from debtors, the company makes an allowance for bad debts on the remaining debtors. This is so because it’s obvious, from experience and industry trends, that part of remaining debtors will turn out to be bad debts.

• This practice is in line with the prudence concept that calls for reporting on figures that provide a fair and true picture of company’s position.Therefore, the allowance for bad debts/doubtful debts/uncollectible ensures the right estimates of accounts receivable are reported.

• The allowance for uncollectible account is used to adjust for the estimated future bad debts. This is a contra asset account to the total debtors/accounts receivable account. A contra asset is an asset a/c with a credit balance. The allowance for uncollectibles account is also referred to as provision for bad debts/doubtful debts account.

The allowance may be estimated by:

• Looking at each debt and deciding to what extent it will be bad.

• On the basis of experience, what percent of the total amount due from the remaining debtors will ultimately prove to be bad debts.

• Aging of receivables.

For the first year the allowance is made:

Dr. Profit and loss a/c Cr. Allowance for uncollectible

(With the actual amount allowed)

• In the next year the provision may be increased or decreased depending on increase or decrease in number of debtors respectively.

Increasing the allowance

• If the allowance is increased, the increase i.e. difference between the old and new provision is recorded as follows:

Dr. profit and loss account Cr. Allowance for uncollectible

ILLUSTRATION

The closing balances of maji moto traders books showed the following:

• Accounts payable 12000

• Allowance for uncollectible 200

• Allowance for bad debts to be maintained at 2%

Show the records in the books of accounts.

• SOLUTION

New allowance:

2/100 *12000 = 240

Increase in allowance for uncollectible:

240 – 200 = 40

Dr. Profit and loss a/c (sh. 40) Cr. Allowance for uncollectible (sh. 40)

Profit and loss account

31/12/09 Allowance for uncollectible 40

Allowance for uncollectibles

1/1/09 Balance b/d 20031/12/09 Profit and loss a/c 40

Decreasing the allowance

• A decrease in the allowance for bad debts is treated as follows:

Dr. Allowance for uncollectible Cr. Profit and loss account

Illustration

A business starts on January 1, 2007 and has its financial year ending on December 31.

Year Bad debts Accounts Receivables

2009 300 7000

2010 400 9000

2011 520 12000

Allowance for bad debts is maintained at 1%.

Required:

• Bad debts a/c for all periods

• Allowances for bad debts a/c for all periods

• Income extracts

• Balance sheet extracts.

31/12/09 various debtors 300 31/12/09 profit and loss 30031/12/10 various debtors 400 31/12/10 profit and loss 40031/12/11 various debtors 520 31/12/11 profit and loss 520

Bad debts

31/12/09 balance c/d 70 31/12/09profit and loss 70

31/12/10 balance c/d 90 1/1/10 balance c/d 70__ 31/12/10 profit and loss 2090 90

31/12/11 balance c/d 120 1/1/11 balance c/d 90__ 31/12/11 profit and loss 30120 120

Allowance for bad debts a/c

Income statement (extracts) for years ending December 312009 Sh. Sh.Gross profit xxxLess: bad debts 300

Allowance for bad debts 70 (370)xxx

2010Gross profit xxxLess: bad debts 400

Allowance for bad debts 20 (420)xxx

2011Gross profit xxxLess: bad debts 520

Allowance for bad debts 30 (550)xxx

Balance sheet extracts2009Accounts receivables 7000Allowance for bad debts (70)

6930

2010Accounts receivables 9000Allowance for bad debts (90)

89102011Accounts receivables 12000Allowance for bad debts (120)

11880

Important notes:

• During exams, the accounts receivable figure given has already been deducted of the bad debts expense. it can therefore be used to estimate allowance for uncollectibles.

• Most Gaap require that the allowance to be debited to the bad debts expense account and later be transferred to the income statement at the end of the financial period.

• The main difference between bad debts account and allowance for bad debts account is that the former is a temporary a/c while the latter is permanent.

• While preparing the balance sheet, the new provision for bad debt is deducted from the amount of debtors.

• In the balance sheet, the entire allowance is deducted from the accounts receivables figure but in the profit and loss account, you only include the changei.e. increase or decrease.

Bad debts recovered

• At times, debts earlier written off as bad debts are recovered, This is recognized by reinstating the debt by debiting the debtor’s account and crediting the bad debts recovered account.

Dr. specific debtor’s a/c Cr. Bad debts recovered a/c

• When payment is received, partially or fully,

Dr. cash/bank a/c Cr. Specific debtor’s a/c.

(with amount received)

• At the end of the financial period, the credit balance of the bad debts recovered a/c is transferred (debited) to the bad debts a/c or the profit and loss account.

PROVISION FOR CASH DISCOUNTS

• After deducting the allowance for doubtful debts from the accounts receivable, a provision for cash discount has to be made. This is because there is a probability that discount will be allowed to debtors to accelerate payment of their debts. The provision for discount is reordered similarly to allowance for bad debts.

Dr. Profit and loss account Cr. provision for cash discounts a/c

• In the subsequent years, only the increase or decrease will be recorded in the profit and loss a/c and provision.

• Increase:

Dr. Profit and loss account Cr. provision for cash discounts a/c

(with the increase)

• Decrease:

Dr. provision for cash discount Cr. Profit and loss account

(with the decrease)

• New provision for discount on debtors is deducted from accounts receivables, after deducting the allowance for bad debts.

Adapted from waruicommerce.blogspot.com