Chapter 2

Notes to teachers
1 2

Bad Debts and Allowance for Doubtful Accounts

Start with Chapter 3 of Frank Woods Introduction to Accounting and briefly explain to students how to record credit sales in the books. Ask students what should be done in the books if it is ascertained that a trade debtor will not be able to settle his outstanding balance, before explaining to them the meaning of bad debts and the required accounting entries. Similarly, ask students what should be done in the books if it is found that a bad debt written off previously has been paid back, before telling them the meaning of bad debts recovered and the required accounting entries. Bad debts may be written off and recovered within the same accounting period or in different accounting periods. Students must note the differences in their accounting treatments. Before teaching students the adjusting entries for creating an allowance for doubtful accounts, it is necessary to introduce the prudence (or conservatism) concept and explain how it affects the profit and loss for an accounting period. The term allowance for doubtful accounts is used in the NSS Curriculum Guide. Students should know the alternative names, such as provision for bad debts, provision for doubtful debts or allowance for doubtful debts. It is more appropriate to use the term allowance instead of provision. Teachers can refer to Chapter 13 of Frank Woods Financial Accounting 2 for the true meaning of provisions. However, it may not be necessary for students to know about the differences between provision and allowance until that chapter. There are two methods for estimating the amount of doubtful accounts. In practice, the use of specific allowances is more common. Most students have difficulty understanding the difference between recording the allowance for doubtful accounts for the first time and in subsequent periods. Teachers can explain it in the following manner:

4 5

8 9
14

Year 1: Suppose at the end of the year, accounts receivable total $100,000. It is decided that a 5% allowance for doubtful accounts is to be created for the first time. As a result, the following entries would be made: Dr Profit and loss $5,000 Cr Allowance for doubtful accounts $5,000 Year 2: Year-end accounts receivable total $120,000. A 5% allowance for doubtful accounts is to be maintained. As a result, the following entries would be made: Dr Profit and loss $6,000 Cr Allowance for doubtful accounts $6,000 The allowance made in the previous year should be reversed: Dr Allowance for doubtful accounts $5,000 Cr Profit and loss $5,000

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 10

This is because if the allowance made in Year 1 turns out to be bad debts in Year 2, the following entries would be made: Dr Bad debts (profit and loss) $5,000* Cr Accounts receivable $5,000* * The actual total for bad debts can be less. If the allowance for doubtful accounts made in Year 1 is not reversed, the loss of $5,000 would have been recorded twice in the books (in Year 1 and Year 2 respectively). Even if the debts can all be collected in Year 2, the allowance for doubtful accounts made in Year 1 should still be reversed because the estimated loss has not been realised. For simplicity, the required entries for the allowance for doubtful accounts in Year 2 would be: Dr Profit and loss $1,000 Cr Allowance for doubtful accounts $1,000 Only the increase ($6,000 $5,000) in the allowance should be recorded. The same logic applies to the recording of a decrease in the allowance for doubtful accounts.

Furthermore, most students have difficulty deciding whether bad debts should be deducted from accounts receivable in calculating the allowance for doubtful accounts. If there are bad debts shown in the trial balance, this means that they have already been deducted from accounts receivable. If bad debts do not appear in the trial balance but are mentioned as additional information in the question, this means they have not been deducted from accounts receivable. An adjustment should then be made to write off the bad debts from accounts receivable. Students should be able to differentiate between: the nature of the bad debts account and the allowance for doubtful accounts account (expense account vs. contra-asset account) gross amount and net amount (net realisable value) of accounts receivable The topic of allowance for discounts allowed is not explicitly spelled out in the NSS Curriculum Guide. However, teachers are advised to teach it as additional material.

11 12

Q1 Q2

Bad debts refer to accounts receivable that have been proved to be uncollectible. The net profit for the period will be reduced by the bad debts written off. Bad debts are treated as an expense of a business. The bad debts account is a nominal account. when a debtor has gone bankrupt and is unable to pay the debt. Once a bad debt arises, it should be immediately written off from the affected debtors account. Doubtful debts refer to accounts receivable that are likely to become uncollectible. Under the prudence concept, an allowance should be made for doubtful accounts at the end of an accounting period. The amount of doubtful accounts is just an estimate.

Q3 Bad debts refer to accounts receivable that have been proved to be uncollectible. This would happen

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Q4

The amount of doubtful accounts can be estimated on either of the following bases: Specific allowance Each debtors account is looked at individually to see whether the debt is likely to become uncollectible. If a debt is likely to become uncollectible, an allowance would then be made, up to the full amount of the debt. General allowance A fixed percentage is applied to the total of accounts receivable. The percentage can be affected by many factors, such as the proportion of accounts receivable written off as bad in past years, the creditworthiness of debtors and the general business environment. Usually, the longer a debt is outstanding, the more likely it will become uncollectible. Therefore, a higher percentage would be applied to those accounts that have been outstanding for a longer period (i.e., older accounts). The net realisable value of accounts receivable refers to the amount of cash that is expected to be collected from them. It is usually calculated as the original amount of accounts receivable, less the bad debts written off and the allowance for doubtful accounts (and the allowance for discounts allowed, if any). Once a bad debt arises, it should be immediately written off from the affected debtors account. At the end of an accounting period, the total of bad debts will be transferred to the profit and loss account as an expense. In addition, an allowance will be made for doubtful accounts at the end of an accounting period as follows: 1 When the allowance for doubtful accounts is made for the first time: Dr Profit and loss account Cr Allowance for doubtful accounts account The entire allowance amount will be recorded in the profit and loss account as an expense.

Q5

Q6

2 When the allowance for doubtful accounts is made in subsequent periods: (a) An increase in the allowance should be recorded as an expense: Dr Profit and loss account Cr Allowance for doubtful accounts account The increase in allowance will be recorded in the profit and loss account as an expense.

(b) A decrease in the allowance should be recorded as other revenue: Dr Allowance for doubtful accounts account Cr Profit and loss account The decrease in allowance will be recorded in the profit and loss account as other revenue.

A1

Under cash accounting, sales are recorded when money is received. The uncollected amounts will not be recorded and separately shown. Therefore, there is no need to write off bad debts.

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A2

Accounts Receivable Ledger

2009 Dec 10 Bad debts

T Yeung
$ 2009 1,000 Dec 10 Bank $ 1,000

General Ledger
2009 May 17 Aug 20 K Lau T Yeung

Bad Debts
$ 4,800 2,400 7,200 2009 Dec 10 " 31 T Yeung (bad debts recovered) Profit and loss $ 1,000 6,200 7,200

A4

In the income statement: Net profit for the year would be total revenues received minus total expenses paid during the year. Sales would be the amount actually received from sales during the year. Purchases would be the amount actually paid for purchases during the year. Discounts received would not be separately shown. The matching concept (which will be explained in Chapter 17 of Frank Woods Financial Accounting 2) would no longer apply. Therefore, no adjustments for opening/closing inventory would be required. Bad debts recovered would not be recorded and separately shown. No adjustments for accrued expenses and prepaid rent would be required. No bad debts would be written off and no allowance would be made for doubtful accounts. In the balance sheet: The items inventory, accounts receivable and prepaid expenses would not appear in current assets. The items accounts payable and accrued expenses would not appear in current liabilities. Bad debts and doubtful debts refer to the amounts proved or estimated to be uncollectible, respectively. Cash discounts are unlikely to be allowed on uncollectible accounts. Only the accounts receivable, after deducting the bad debts written off and the allowance for doubtful accounts, could enjoy cash discounts by paying within the cash discount period.

A5

ASSESSMENT

Short Questions
1
2009 Jan 1 Balance b/f

D Fung
$ 2,000 2,000 2009 Feb " 1 1 Cash Bad debts $ 1,500 500 2,000

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C Chang
2009 Jan 1 Balance b/f $ 1,200 1,200 2009 Mar 10 " 10 Cash ($1,200 30%) Bad debts $ 360 840 1,200

Bad Debts
2009 Feb 1 Mar 10 D Fung C Chang $ 500 840 1,340 2009 Dec 31 Profit and loss $ 1,340 1,340

2X
2008 2009 Bad debts Bad debts

Income Statements for the years ended 31 December (extract)

$ 2,000 3,000

Balance Sheets as at 31 December (extract)

2008 2009 Accounts receivable Accounts receivable $ 38,000 57,000

Application Problems
3
2005 Mar 31 2006 Mar 31 2008 Mar 31 Accounts receivable Accounts receivable Accounts receivable

Bad Debts
$ 2005 10,000 Mar 31 2006 5,000 Mar 31 2008 6,000 Mar 31 Profit and loss Profit and loss Profit and loss $ 10,000 5,000 6,000

Allowance for Doubtful Accounts

2005 Mar 31 2006 Mar 31 2007 Mar 31 " 31 2008 Mar 31 Balance c/f Balance c/f $ 3,000 3,750 3,750 2005 Mar 31 2005 Apr 1 2006 Mar 31 Profit and loss [($70,000 $10,000) 5%] Balance b/f $ 3,000

3,000

Profit and loss {[($80,000 $5,000) 5%] $3,000} Balance b/f Balance b/f

750 3,750 3,750 3,750 3,000

2006 Profit and loss [$3,750 ($60,000 5%)] 750 Apr 1 Balance c/f 3,000 3,750 Balance c/f 3,200 3,200 2007 Apr 1 2008 Mar 31

Profit and loss {[($70,000 $6,000) 5%] $3,000}

200 3,200

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Incomes Statements for the years ended 31 March (extract)

2005 2006 Bad debts Allowance for doubtful accounts Bad debts Allowance for doubtful accounts (increase) $ 10,000 3,000 5,000 750 2007 6,000 200 Allowance for doubtful accounts (reduction) 750 $

2008

Bad debts Allowance for doubtful accounts (increase)

Balance Sheets as at 31 March (extract)

2005 2006 2007 2008 Accounts receivable Less Allowance for doubtful accounts Accounts receivable Less Allowance for doubtful accounts Accounts receivable Less Allowance for doubtful accounts Accounts receivable Less Allowance for doubtful accounts $ 60,000 (3,000) 75,000 (3,750) 60,000 (3,000) 64,000 (3,200) $ 57,000

71,250

57,000

60,800

4X

(a) (i)
2006 Dec 31 2007 Dec 31 2008 Dec 31 2009 Dec 31 Accounts receivable Accounts receivable Accounts receivable Accounts receivable

Bad Debts
$ 2006 2,980 Dec 31 2007 3,860 Dec 31 2008 3,440 Dec 31 2009 4,770 Dec 31 Profit and loss Profit and loss Profit and loss Profit and loss $ 2,980 3,860 3,440 4,770

(ii)
2006 Dec 31 2007 Dec 31 2008 Dec 31 " 31 2009 Dec 31 Balance c/f Balance c/f Profit and loss Balance b/f Balance c/f

Allowance for Doubtful Accounts

$ 2006 3,000 Dec 31 3,300 3,300 150 3,150 3,300 3,500 3,500 2007 Jan 1 Dec 31 2008 Jan 1 2009 Jan 1 Dec 31 Profit and loss Balance b/f Profit and loss Balance b/f Balance b/f Profit and loss Balance b/f $ 3,000 3,000 300 3,300 3,300 3,300 3,150 350 3,500 3,500

2010 Jan 1

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(iii)
2006 2007 2008 2009

Income Statements for the years ended 31 December (extract)

Bad debts Allowance for doubtful accounts Bad debts Allowance for doubtful accounts Bad debts Bad debts A llowance for doubtful accounts $ 2,980 3,000 3,860 300 3,440 2008 4,770 350 Allowance for doubtful accounts 150 $

(iv)
2006 2007 2008 2009

Balance Sheets as at 31 December (extract)

Accounts receivable Less Allowance for doubtful accounts Accounts receivable Less Allowance for doubtful accounts Accounts receivable Less Allowance for doubtful accounts Accounts receivable Less Allowance for doubtful accounts $ 120,000 (3,000) 150,000 (3,300) 140,000 (3,150) 180,000 (3,500) $ 117,000 146,700 136,850 176,500

(b) Bad debts refer to accounts receivable that have been proved to be uncollectible. This would happen when a debtor has gone bankrupt and is unable to pay the debt. Under the prudence concept, an allowance should be made at the end of an accounting period for accounts receivable that are likely to become uncollectible (i.e., doubtful accounts). The amount of doubtful accounts is just an estimate. (a) (i)
2007 Sept 30 2008 Sept 30 " 30 Balance c/f Profit and loss Balance c/f

5X

Allowance for Doubtful Accounts

$ 2007 1,060 Sept 30 60 Oct 1,000 1,060 Profit and loss [($12,000 $600 $800) 10%] 1 Balance b/f $ 1,060 1,060 1,060

(ii)
2007

T Young Income Statements for the years ended 30 September (extract)

Bad debts ($600 + $800) A llowance for doubtful accounts $ 1,400 1,060 2008 $

Allowance for doubtful accounts

60

(iii)
2007 2008

T Young Balance Sheets as at 30 September (extract)

Accounts receivable Less Allowance for doubtful accounts Accounts receivable Less Allowance for doubtful accounts $ 10,600 (1,060) 10,000 (1,000) $ 9,540

9,000

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(b) A fixed percentage is applied to the total of accounts receivable. The percentage can be affected by many factors, such as the proportion of accounts receivable written off as bad in past years, the creditworthiness of debtors and the general business environment. The management should review the percentage regularly and make changes if necessary to ensure that an adequate allowance is made to cover possible bad debts. (a)
2008 Mar 31 2009 Mar 31 Accounts receivable Accounts receivable

Bad Debts
$ 2008 2,000 Mar 31 2009 1,500 Mar 31 Profit and loss Profit and loss $ 2,000 1,500

(b)
2009 Mar 31 Profit and loss

Bad Debts Recovered

$ 2009 500 Jan 31 Mr Robinson $ 500

(c)
2008 Mar 31 2009 Mar 31 Balance c/f Balance c/f

Allowance for Doubtful Accounts

$ 2008 320 Mar 31 2008 480 Apr 1 2009 Mar 31 480 $ Profit and loss [($18,000 $2,000) 2%] 320 Balance b/f 320 160 480

Profit and loss [($24,000 2%) $320]

(d)
2008 2009

Income Statements for the years ended 31 March (extract)

Bad debts Allowance for doubtful accounts Bad debts Allowance for doubtful accounts (increase) $ 2,000 320 $

1,500 2009 160

Bad debts recovered

500

7X

(a)
2007 Dec 31 2008 Dec 31 2009 Dec 31 Accounts receivable Accounts receivable Accounts receivable

Bad Debts
$ 2007 2,400 Dec 31 2008 3,200 Dec 31 2009 4,700 Dec 31 Profit and loss Profit and loss Profit and loss $ 2,400 3,200 4,700

(b)
2008 Dec 31 2009 Dec 31 Profit and loss Profit and loss

Bad Debts Recovered

$ 2008 700 Nov 30 2009 300 Dec 31 Mrs P Yip Accounts receivable $ 700 300

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(c)
2007 Dec 31 2008 Dec 31 2009 Dec 31 " 31 Balance c/f Balance c/f ($112,000 5%) Profit and loss Balance c/f ($84,000 5%)

Allowance for Doubtful Accounts

$ 2007 4,000 Dec 31 5,600 5,600 2008 Jan 1 Dec 31 Profit and loss Balance b/f Profit and loss Balance b/f $ 4,000 4,000 1,600 5,600 5,600 5,600

2009 1,400 Jan 1 4,200 5,600

(d)
2007 2008 2009

Income Statements for the years ended 31 December (extract)

Bad debts A llowance for doubtful accounts Bad debts Allowance for doubtful accounts (increase) Bad debts $ 2,400 4,000 $

3,200 2008 1,600 4,700 2009

Bad debts recovered

700

Allowance for doubtful accounts (reduction) Bad debts recovered

1,400 300

8
2009 Dec 31 Accounts receivable

Bad Debts
$ 2009 2,960 Dec 31 Profit and loss $ 2,960

Allowance for Doubtful Accounts

2009 Dec 31 Balance c/f $ 1,132 1,132 2009 Jan 1 Dec 31 $ Balance b/f 672 Profit and loss {[($25,600 $2,960) 5%] $672} 460 1,132

Allowance for Discounts Allowed

2009 Dec 31 Balance c/f $ 538 538 2009 Jan 1 Dec 31 Balance b/f Profit and loss {[($25,600 $2,960 1 $1,132) 2 %] $430} 2 $ 430 108 538

Income Statement for the year ended 31 December 2009 (extract)

Bad debts Allowance for doubtful accounts (increase) Allowance for discounts allowed (increase) $ 2,960 460 108

Balance Sheet as at 31 December 2009 (extract)

Accounts receivable Less Allowance for doubtful accounts Allowance for discounts allowed $ 1,132 538 (1,670) 20,970 $ 22,640

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9X

(a)

Income Statement for the year ended 31 March 2006 (extract)

$ 14,000 9,600 6,208

Bad debts Allowance for doubtful accounts [($334,000 $14,000) 3%] A llowance for discounts allowed [($334,000 $14,000 $9,600) 2%]

Income Statement for the year ended 31 March 2007 (extract)

$ A llowance for doubtful accounts (increase) [($415,000 3%) $9,600] 2,850 A llowance for discounts allowed (increase) {[($415,000 $9,600 $2,850) 2%] $6,208} 1,843

Income Statement for the year ended 31 March 2008 (extract)

$ Allowance for doubtful accounts (reduction) [($360,000 2%) $9,600 $2,850] 5,250 Allowance for discounts allowed (reduction) {[($360,000 $7,200) 2%] $6,208 $1,843} 995 Bad debts recovered 7,000

(b)
Current assets Accounts receivable Less Allowance for doubtful accounts Allowance for discounts allowed

Balance Sheet as at 31 March 2006 (extract)

$ 9,600 6,208 (15,808) 304,192 $ 320,000

Balance Sheet as at 31 March 2007 (extract)

Current assets Accounts receivable Less Allowance for doubtful accounts Allowance for discounts allowed $ 12,450 8,051 (20,501) 394,499 $ 415,000

Balance Sheet as at 31 March 2008 (extract)

Current assets Accounts receivable Less Allowance for doubtful accounts Allowance for discounts allowed $ 7,200 7,056 (14,256) 345,744 $ 360,000

(c) Possible reasons: Decreasing proportion of accounts receivable written off as bad in past years Improvement in the overall creditworthiness of trade debtors Improvement in the general business environment (Any acceptable reason) 23

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10

(a)
2006 Dec 31 2007 Dec 31 2008 Dec 31 " 31 Balance c/f Balance c/f Profit and loss Balance c/f

Allowance for Doubtful Accounts

$ 6,810 6,810 12,415 12,415 2006 Jan 1 Dec 31 2007 Jan 1 Dec 31 Balance b/f Profit and loss Balance b/f Profit and loss Balance b/f $ 4,200 2,610 6,810 6,810 5,605 12,415 12,415 12,415

2008 5,800 Jan 1 6,615 12,415

(b)

Stephen Co Ltd Balance Sheet as at 31 December 2008 (extract)

$ 99,250 (6,615) $

Current assets Accounts receivable ($104,000 $4,750) Less Allowance for doubtful accounts

92,635

11

(a) Dr Allowance for doubtful accounts $900 ($4,200 $3,300*) Cr Profit and loss $900 * $32,000 2% + $28,000 4% + $14,000 6% + $7,000 10% Dr Profit and loss $7,736* Cr Allowance for discounts allowed $7,736 * $46,000 10% + $32,000 98% 10% (This is the most conservative estimate.)

(b) $115,964 ($127,000 $3,300 $7,736) (c) sually, the longer a debt is outstanding, the more likely it is to become uncollectible. Therefore, a U higher percentage is applied to those accounts that have been outstanding for a longer period (i.e., older accounts).

12X (a) Bad debts are written off when accounts receivable have been proved to be uncollectible. This would
happen when a debtor has gone bankrupt and is unable to pay the debt. In addition, an allowance is to be made at the end of the financial year for accounts receivable that are likely to become uncollectible (i.e., doubtful accounts). The amount of allowance for doubtful accounts is just an estimate.

(b) An increase in the allowance for doubtful accounts represents an additional loss arising on accounts receivables and is thus treated as an expense for the year. (c) Discounts allowed refer to cash discounts given to trade debtors who pay within the cash discount period. In addition, an allowance for cash discounts is made at the end of the financial year on accounts receivable that are likely to be settled within the cash discount period. The amount of allowance for discounts allowed is just an estimate. (d) A decrease in the allowance for discounts allowed represents a reversal of loss arising from accounts receivables and is thus treated as other revenue for the year.

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(e) This is an application of the prudence concept under accrual accounting. For the sake of prudence, an allowance should be made for possible expenses or losses, whether the amount is certain or just an estimate. (f) This could happen when more accounts receivable are estimated to be uncollectible and fewer accounts receivable are expected to be settled with the cash discount period.

Past Exam Questions

13X (a)
Mr Ho Journal
Dr 2005 (ii) Mar 31 (iii) " 31 Bad debts Mr Tam (debtor) Profit and loss [($939,000 $6,000) 3%] Provision for doubtful debts Mr Tam (debtor) Bad debts recovered Bank Mr Tam (debtor) 31 Provision for doubtful debts Profit and loss [$27,990 ($332,800 2%)] $ 6,000 27,990 27,990 4,000 4,000 4,000 4,000 21,334 21,334 Cr $ 6,000

2006 (iv) Mar 27 (v) "

(b) (i)

Profit and Loss Account for the year ended 31 March 2006 (extract)
$ 21,334 4,000

Other income Decrease in provision for doubtful debts Bad debts recovered

(ii)

Balance Sheet as at 31 March 2006 (extract)

$ 332,800 (6,656) 326,144

Current assets Debtors Less Provision for doubtful debts

(c)

The estimated amount of the provision for doubtful debts can be made: (i) from experience in past years (ii) by listing debtors whose debts can be regarded as doubtful (iii) with reference to the general economic condition (iv) by preparing an ageing schedule where the debtors are analysed according to the length of time that the debts have been outstanding (Any two points)

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