Most businesses offer their customers credit, so they can buy now, and pay later. Typically businesses offer 30 days, but it can be a much longer period, especially if the customer has a lot of power over its suppliers, think of a cabbage farmer in Yorkshire selling to a large national supermarket.
However, once a business starts to get a number of customers, unfortunately, it will find that not everyone will pay their debts, these debts are known as “bad debts”, for obvious reasons.
A business needs to account for a bad debt as soon as it knows it has gone bad, so it is not overstating its trade receivables. This article explains how we do this. We also have a supporting article on cashflow forecasts, which you are welcome to read.
The double entry for a bad debt will be:
Debit bad debt expense account
Credit trade receivables
We debit the bad debt expense account, we don’t debit sales to remove the sale. The sale was still made but we need to show the expense of not getting paid.We then credit trade receivables to remove the asset of someone owing us money.Remember under DEADCLIC, an asset is a debit, and so to remove it we enter a credit.
If the business was VAT registered we may have already paid HMRC VAT which wasn’t received from our customers. Therefore, we are out of pocket. We can get this back from HMRC, this is known as Bad debt relief. You will note in the double entry above we haven’t touched the VAT account. You can only get bad debt relief after the invoice is more than 6 months overdue. So if you normally give your customers 3 months credit, you can’t obtain bad debt relief until the invoice is 9 months old.
Accountants have to abide by the concept of prudence, and should only show trade receivables which they think they will receive. This is ok if you know which customer’s debts have gone bad. However, if you have lots of customers, past history will tell you that some will almost definitely go bad, but you just don’t know which ones. In this situation you enter a provision for an amount which you think will go bad, so your accounts only show an amount which you are likely to receive from your customers.
The double entry here will be:
Debit bad debt provision expense P+L
Credit bad debit provision B/S
The credit of the provision will offset the debit of the receivables to come to a more realistic figure which is likely to be received from the customers.
Once you have entered a provision one year, the amount which you think will go bad is very unlikely to be the same the following year. This could be because the amount you have outstanding from your customers has gone up, therefore you expect more debts to go bad, or you have implemented a new credit control procedure so less debts are going bad.
Say for example we had previously introduced a bad debt provision of £500. This year the debtors are now £100,000, and we expect 0.6% of these to go bad, based on previous experience.So we need a bad debt provision of £600, £100,000 x 0.6%.However, there is already a provision of £500, so we just need to increase this by £100. We do not need to enter the whole £600, we are just adjusting the earlier provision.
The double entry would be:
Debit bad debt provision expense P+L £100
Credit Bad provision £100 B/S
If however, we had calculated that the provision should have been £400, we would have to reduce our provision. To reduce a provision, which is a credit, we enter a debit.The other side would be a credit, which would go to the bad debt provision expense account.You will note we are crediting an expense account.This is acts a negative expense and will increase profit for the period.
The double entry will be:
Debit Bad debt provision B/S £100
Credit Bad debt expense account P+L £100
Remember, once a provision has been created you will only ever post the movement from one year’s provision to the next.
If you have a specific bad debt, i.e. you know who the debt is, and how much it is, you would deduct this before calculating the provision.
So taking our example above, if we had receivables of £100,000, but you knew that £5,000 owing from a certain customer had gone bad, you would deduct this, and base the 0.6% on £95,000, which would mean you need a provision of £570.
Why don’t you have a go at the following example?
Green Apple Ltd has trade receivables of £80,000 at the end of 20X6, and has decided to introduce a bad debt provision of 5%.
At the end of 20X7, the trade receivables figure has risen to £120,000, however, within that is an amount owing from Blue Grape PLC, of £5,000 which needs to be written off as they have gone into liquidation. During the year, Green Apple Ltd recruited a new credit controller, and it is felt that the bad debt provision should be based on 3%.
What are the bad debt transactions at the end of 20X6 and at the end of 20X7?
Watch me work through my examples below:
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