Allowance for Irrecoverable Debts (Cambridge International A-Level Accounting)

Allowance for irrecoverable debts

What is an allowance for irrecoverable debts?

• An allowance for irrecoverable debts is an estimation for the amount of sales in a given financial period which will result in irrecoverable debts

• The amount for the allowance for irrecoverable debts can be determined using different methods

  • It could be a fixed percentage of the trade receivables at the end of a financial period
  • It could be a fixed amount based on data from previous years
  • It could factor in how long debts have been outstanding
  • It could be based on which individuals are unlikely to settle their debts

• A business should use the same method for accounting for the allowance each year

  • This adheres to the accounting principle of consistency

• An allowance for irrecoverable debts is similar to a provision for depreciation of a non-current asset

  • The allowance for irrecoverable debts estimates a reduction in an asset

    • The asset is the amount owed by trade receivables

  • However, the reduction is kept in an allowance account which is separate from the asset accounts

Why do businesses set up allowance for irrecoverable debts?

• Businesses use an allowance for irrecoverable debts to adhere to the accounting principles:

  • Prudence
  • Matching

• The principle of prudence is applied because:

  • The assets are not overstated

    • The allowance reduces the trade receivables by a realistic amount

  • The profit for the year is not overstated

    • The potential losses are factored into the expenses

• The principle of matching is applied because:

  • An estimate of irrecoverable debts is made based on sales in a given period
  • This estimate is then treated as an expense for the same period as the original sales

How do I set up an allowance for irrecoverable debts?

• The allowance is set up at the end of the financial period

• The business estimates the amount of sales in that period that will result in irrecoverable debts

  • This is normally a percentage of the trade receivables at the end of the financial period

• This amount is debited to the statement of profit or loss as an expense

  • A credit entry is made in the allowance for irrecoverable debts account

• The balance of an allowance for irrecoverable debts account will be on the credit side because it represents a reduction in an asset

Exam Hint No entries are made in any account in the sales ledger for the allowance for irrecoverable debts. Entries are made in these accounts when debts are actually written off.

Worked Example On 31 March 2024, Josef is owed $42 000 by credit customers. Josef decides to create an allowance for irrecoverable debts, set at 5% of trade receivables.

Prepare journal entries for the creation of an allowance for irrecoverable debts account on 31 March 2024. A narrative is not required.

Journal

Date	Details	Debit $**	Credit **$

Answer:

• Calculate the allowance for irrecoverable debts

5% × $42 000 = $2 100

• Start with the account to be debited

  • The statement of profit or loss

• Then include the account to be credited

  • The allowance for irrecoverable debts account

Journal

Date	Details	Debit $**	Credit $
Final answer: 2024 Final answer: Mar 31	Final answer: Statement of profit or loss	Final answer: 2 100
	** Allowance for irrecoverable debts		Final answer: 2 100

Adjustments to an allowance for irrecoverable debts

How do I update an allowance for irrecoverable debts at the end of a financial period?

• The allowance for irrecoverable debts is reviewed at the end of each year and the amount might be updated

• At the end of the financial period

  • Calculate the new allowance for irrecoverable debts

  • This will be the opening balance of the allowance for irrecoverable debts account for the next financial period

    • Enter it on the credit side

  • Enter the corresponding closing balance on the debit side of the allowance for irrecoverable debts account for the current financial period

  • Calculate the difference and enter it on the appropriate side to make the account balance

    • This value will be transferred to the statement of profit or loss

• If the allowance for irrecoverable debts increases:

  • The difference will be on the credit side
  • This will be debited to the statement of profit or loss as an expense

• If the allowance for irrecoverable debts decreases:

  • The difference will be on the debit side
  • This will be credited to the statement of profit or loss as an income

How does an allowance for irrecoverable debts affect the financial statements?

• At the end of a financial period, the balance from the allowance for irrecoverable debts account appears on the statement of financial position

  • It is listed under trade receivables
  • The balance is subtracted from the balance for trade receivables

• The difference in the allowance between the start of the year and the end of the year appears on the statement of profit or loss

  • If the allowance has increased, it appears with the other expenses
  • If the allowance has decreased, it appears with the other income

Exam Hint When an allowance for irrecoverable debts is first created, the whole amount is charged as an expense to the statement of profit or loss, this is because the allowance has increased from $0.

Worked Example Ricardo keeps an allowance for irrecoverable debts at a rate of 3% of trade receivables. On 1 March 2023, the balance of the allowance for irrecoverable debts was $1 530. On 29 February 2024, the trade receivables were $49 500, of which $1 000 should be written off as irrecoverable debts.

(a) Prepare the allowance for irrecoverable debts account for Ricardo. Balance the account on 29 February 2024 and bring down the balance on 1 March 2024.

(b) State how the allowance for irrecoverable debts affects the profit for the year ended 29 February 2024.

Answer:

• Subtract the irrecoverable debts from the trade receivables

$49 500 - $1 000 = $48 500

• Calculate the new allowance for irrecoverable debts

3% × $48 500 = 1 455

• Calculate the change in the allowance

$1 530 - $1 455 = $75

(a)

Enter the details into the allowance for irrecoverable debts account

• Remember, the balance b/d is on the credit side

Final answer: Ricardo Allowance for Irrecoverable Debts Account

Final answer: Date	Final answer: Details	Final answer: $**	Final answer: Date	Final answer: Details	Final answer: $
Final answer: 2024 Final answer: Feb 29	Final answer: Statement of profit or loss	Final answer: 75	Final answer: 2023 Final answer: Mar 1	Final answer: Balance b/d	Final answer: 1 530
Final answer: Feb 29	Final answer: Balance c/d	Final answer: 1 455
		Final answer: 1 530			Final answer: 1 530
			Final answer: 2024 Final answer: Feb 29	Final answer: Balance b/d	Final answer: 1 455

**(b)

The allowance for irrecoverable debts has decreased. This will be credited to the statement of profit or loss and treated as an income.

Final answer: The allowance for irrecoverable debts increases the profit for the year by $75