Question

The receivables allowance reduces the reported trade receivables balance to reflect uncertainties over collectability. Explain the concept of allowances for irrecoverable receivable and describes the allowances for receivables information which could be given in annual report.

Answer 1

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Explain the concept of allowances for irrecoverable receivable:

The majority of businesses will sell to their customers on credit and state a defined time within which they must pay (a credit period).

Where credit facilities are offered, it is normal for a business to maintain an aged receivables analysis.

Analysis is usually a list, ordered by name, showing how much each customer owes and how old their debts are.

The credit control function of a business uses the analysis to keep track of outstanding debts and follow up any that are overdue.

Timely collection of debts improves cash flow and reduces the risk of them becoming irrecoverable.

It is also normal for a business to set a credit limit for each customer. This is the maximum amount of credit that the business is willing to provide.

Some customers may refuse to pay their debt or be declared bankrupt and unable to pay the amounts owing.

Some customers may be in financial difficulties or may dispute the amount owed and there may be some doubt as to whether their debt will be paid.

If it is highly unlikely that the amount owed by a customer will be received, then this debt is known as an irrecoverable debt. As it will probably never be received, it is written off by writing it out of the ledger accounts completely.

If there is some doubt whether a customer can or will pay his debt, an allowance for receivables is created. These debts are not yet irrecoverable. However the creation of an allowance for receivables means that the possible loss is accounted for immediately, in line with the concept of prudence. The amount of the original debt will still remain in the ledger account just in case the customer does eventually pay.

There may be some debts in the accounts where there is some cause for concern but they are not yet definitely irrecoverable.

It is prudent to recognize the possible expense of not collecting the debt in the income statement, but the receivable must remain in the accounts in case the customer does in fact pay up.

An allowance is set up which is a credit balance. This is netted off against trade receivables in the statement of financial position to give a net figure for receivables that are probably recoverable.

There are two types of allowance that may appear in the organization's accounts:

There will be some specific debts where the customer is known to be in financial difficulties, is disputing their invoice, or is refusing to pay for some other reason (bad service for example), and therefore the amount owing may not be recoverable. The allowance for such a debt is known as a specific allowance.

The past experience and history of a business will indicate that not all of its trade receivables will be recoverable in full. It may not be possible to identify the amount that will not be paid but an estimate may be made that a certain percentage of customers are likely not to pay. An additional allowance will be made for these items, often known as a general allowance.

Accounting for the allowance for receivables

An allowance for receivables is set up with the following journal: Dr Irrecoverable debts expense Cr Allowance for receivables

If there is already an allowance for receivables in the accounts (opening allowance), only the movement in the allowance is charged to the income statement (closing allowance less opening allowance).

As the allowance can increase or decrease, there may be a debit or a credit in the irrecoverable debts account so the above journal may be reversed.

When calculating and accounting for a movement in the allowance for receivables, the following steps should be taken:

(1) Write off irrecoverable debts. (2) Calculate the receivables balance as adjusted for the write-offs. (3) Ascertain the specific allowance for receivables required. (4) Deduct the debt specifically provided for from the receivables balance (be sure to deduct the full amount of debt rather than the amount of specific allowance). (5) Multiply the remaining receivables balance by the general allowance percentage to give the general allowance required. (6) Add the specific and general allowances required together. (7) Compare to the brought forward allowance. (8) Account for the change in allowance.

The allowances for receivables information which could be given in annual report:

The allowance for doubtful accounts is a balance sheet contra asset account that reduces the reported amount of accounts receivable. The use of this allowance account will result in a more realistic picture of the amount of the accounts receivable that will be turning to cash, since some customers may not pay the full amount owed to the company.

The credit balance in the allowance account is an estimate amount in an adjusting entry that debits the income statement account Bad Debts Expense and credits Allowance for Doubtful Accounts. While the allowance account is recommended for the company's financial statements, it is not acceptable for income tax purposes.