Irrecoverable debts and allowance for irrecoverable debts
This process involves two simultaneous actions:
- Recognizing the expense: The loss is recorded in the Income Statement as an operating expense.
- Removing the asset: The amount is removed from Trade Receivables (the Sales Ledger) because the customer no longer owes this money.
Building on the concept of double-entry bookkeeping, we debit the expense account and credit the asset account.
Journal Entry:
\text{Dr Irrecoverable Debts (Income Statement)}
\text{Cr Trade Receivables Ledger (Customer's Account)}
1. Journal Entry:
| Date | Account Debited | Account Credited | Narrative |
|---|---|---|---|
| 31 Mar 2025 | Irrecoverable Debts | Tahir (Trade Receivables) | Amount due from Tahir written off as irrecoverable |
2. Tahir’s Ledger Account (Sales Ledger):
Before the write-off, Tahir had a debit balance of 500. The credit entry reduces this to zero.</p> <table> <thead> <tr> <th style="text-align:left">Date</th> <th style="text-align:left">Details</th> <th style="text-align:left">
Date
Details
$
1 Apr 2024
Balance b/d
500
31 Mar 2025
Irrecoverable Debts
500
Balance c/d
0
Total
500
Total
500
The Correction: You must credit Trade Receivables (the specific customer's account). The cash was never received; you are simply removing the claim to that cash. Crediting Bank would imply you paid someone else, which is incorrect.
Why examiners accept this: The narrative confirms you understand which account is being credited (the specific customer) and why (it is irrecoverable).
Correct Usage: Always use the phrase: "Amount due from [Customer Name] written off as irrecoverable." Do not just write 'Bad debt' or 'Write-off'; be specific about the customer's name to show you are updating their individual ledger account.
Credit: Tahir’s account (Trade Receivables ledger)
Sometimes, a customer whose debt was previously written off suddenly pays. This is called an irrecoverable debt recovered. Accounting standards require two steps:
- Reinstatement: Reverse the original write-off to put the debt back on the customer's books.
- Payment: Record the receipt of cash as normal.
\text{Dr Trade Receivables Ledger (Customer's Account)}
\text{Cr Irrecoverable Debts (Income Statement)}
(This reverses the expense and restores the receivable)
Step 2: Payment Received
\text{Dr Cash at Bank}
\text{Cr Trade Receivables Ledger (Customer's Account)}
| Date | Account Debited | Account Credited | Narrative |
|---|---|---|---|
| May 2025 | Tahir (Trade Receivables) | Irrecoverable Debts | Amount previously written off now recovered |
2. Payment Journal:
| Date | Account Debited | Account Credited | Narrative |
|---|---|---|---|
| May 2025 | Cash at Bank | Tahir (Trade Receivables) | Receipt of payment from Tahir |
3. Tahir’s Ledger Account Impact:
| Date | Details | </th> <th style="text-align:left">Date</th> <th style="text-align:left">Details</th> <th style="text-align:left"> | |||
|---|---|---|---|---|---|
| 31 Mar 2025 | Irrecoverable Debts | 500 | May 2025 | Irrecoverable Debts (Reinstatement) | 500 |
| May 2025 | Cash at Bank | 500 | |||
| Total | 500 | Total | 500 |
(Note: The net balance remains zero, but the Income Statement is credited in Step 1, increasing profit.)
The Correction: You must reinstate the debt first (Debit Receivables, Credit Income Statement) before recording the cash receipt. This ensures the Trade Receivables ledger accurately reflects that the customer did pay, which is important for their credit history and future credit limits.
Why examiners accept this: The recovery increases profit because it reduces the total irrecoverable debts expense (or creates a credit entry). It also increases cash.
Correct Usage: When asked to explain the effect, state: "Profit increases because the irrecoverable debts expense is reduced. Cash at bank increases." Do not say 'Revenue increases'; this is a correction of an expense, not new sales.
- Dr Trade Receivables (Customer), Cr Irrecoverable Debts
- Dr Cash at Bank, Cr Trade Receivables (Customer)
The Need for an Allowance:
- Prudence/Conservatism: Assets should not be overstated. Trade receivables are shown at their net realizable value.
- Matching Principle: The cost of bad debts is matched to the year in which the sales were made, not just when they go bad later.
This allowance is a contra-asset. It reduces the value of Trade Receivables on the Statement of Financial Position (Balance Sheet).
Calculation Base: The allowance is calculated on Trade Receivables balance after deducting any specific irrecoverable debts written off during the current year.
\text{New Allowance} = \text{Closing Trade Receivables (net of write-offs)} \times \text{Percentage}
Scenario:
- Trade Receivables at 31 March 2024 (before any adjustments): 10,000</li> <li>A debt of500 was written off as irrecoverable during the year.
- The business maintains an allowance for irrecoverable debts of 5% of closing trade receivables.
- The existing allowance at 1 April 2024 was $300.
\text{Closing Balance} = 10,000 - 500 = 9,500
(Note: We deduct the write-off first. This is a critical step often tested.)
Step 2: Calculate New Allowance
\text{New Allowance} = 9,500 \times 5% = 475
Step 3: Determine the Adjustment (Increase or Decrease)
- Existing Allowance (Credit balance): 300</li> <li>New Required Allowance (Credit balance):475
- Increase needed: 475 - 300 = 175
Step 4: Journal Entry for the Increase
\text{Dr Irrecoverable Debts Expense (Income Statement)} \quad 175
\text{Cr Allowance for Irrecoverable Debts} \quad 175
This is a nominal account (or provision account) that tracks the balance of the allowance.
Structure:
- Credit Side: Opening Balance b/d, Increase in Allowance (from Income Statement)
- Debit Side: Decrease in Allowance (to Income Statement), Closing Balance c/d
| Date | Details | $ | Date | Details | $ |
|---|---|---|---|---|---|
| 31 Mar 2025 | Income Statement (Increase) | 175 | 30 Sep 2025 | Balance c/d | 475 |
| 1 Apr 2025 | Balance b/d | 300 | |||
| Total | 775 | Total | 775 |
The Correction: Always deduct specific irrecoverable debts written off in the current year from the Trade Receivables balance before applying the percentage. The allowance is only for the remaining receivables that are still outstanding.
Why examiners accept this: A decrease in the allowance reduces the expense, thereby increasing profit. It is the reverse of an increase.
Correct Usage:
Journal: Dr Allowance for Irrecoverable Debts / Cr Irrecoverable Debts (Income Statement).
In the ledger account, the decrease appears on the Debit side as 'Income Statement'. Do not forget to debit the allowance account to reduce its credit balance.
| Date | Details | </th> <th style="text-align:left">Date</th> <th style="text-align:left">Details</th> <th style="text-align:left"> | |||
|---|---|---|---|---|---|
| 31 Mar 2025 | Income Statement (Increase) | 175 | 30 Sep 2025 | Balance c/d | 475 |
| 1 Apr 2025 | Balance b/d | 300 | |||
| Total | 775 | Total | 775 |
Note: The 175 is the balancing figure representing the increase charged to the Income Statement. The475 balance c/d becomes the new allowance on the SOFP.
- The change in the allowance (increase or decrease) is shown as an operating expense (if increase) or other income/reduction of expense (if decrease).
- It is not the total allowance amount.
Statement of Financial Position (SOFP):
- Trade Receivables are shown at their gross amount.
- The new allowance is deducted below this line to show the net realizable value.
\text{Non-current assets}
\text{Current assets}
\quad \text{Trade receivables} \quad 9,500
\quad \text{Less: Allowance for irrecoverable debts} \quad (475)
\quad \text{Net trade receivables} \quad 9,025
The Correction: The allowance is a credit balance. In the trial balance, it appears on the credit side. However, in the SOFP, it is subtracted from Trade Receivables (a debit balance asset). Do not confuse the Trial Balance position with the Financial Statement presentation.
Context: Questions often ask 'State one reason why a business maintains an allowance for irrecoverable debts.'
Why examiners accept this: The answer must relate to accounting principles (Prudence/Matching) or accuracy of financial statements.
Correct Usage: Use phrases like:
- "To ensure trade receivables are shown at their net realizable value."
- "To match the cost of bad debts to the year in which the sales were made."
- "To provide a more accurate picture of profit by anticipating future losses."
Avoid vague answers like 'Because some people don't pay.' Be specific about the accounting purpose.
Meaning: It is an estimate of the amount which a business will lose in a financial year because of irrecoverable debts.
Effect:
- Profit: Decreases (because it is an expense).
- Trade Receivables: Decreases (on the Statement of Financial Position, as it is deducted from the gross balance).