Learning Outcomes
After reading this article, you will be able to explain the purpose and necessity of an allowance for doubtful debts, state the key principles for recognizing and measuring it, and identify audit risks and substantive procedures linked to receivables and bad debts. You will be able to discuss assertions affected, describe common control failures, and recommend appropriate audit procedures for gathering sufficient, appropriate evidence over receivables’ valuation.
ACCA Audit and Assurance (AA) Syllabus
For ACCA Audit and Assurance (AA), you are required to understand the accounting and audit treatment for allowance for doubtful debts as part of receivables, including audit objectives, risks and substantive procedures, and factors affecting audit evidence.
- Identification and explanation of audit objectives and substantive procedures for receivables and revenue, including collectability and valuation of balances.
- Discussion of the risks of material misstatement relating to the allowance for doubtful debts.
- Description of the recognition and measurement criteria for doubtful debts and their audit implications.
- Evaluation of audit evidence supporting receivables’ recoverability.
- Responses to control deficiencies in the credit control process.
- Design and implementation of audit tests for valuation and existence assertions concerning receivables.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which financial statement assertion is primarily affected if an inadequate allowance for doubtful debts is made?
- The aged receivables listing for a client shows several balances over 120 days overdue. What risk does this create, and what substantive procedure should an auditor perform in response?
- What audit evidence would provide the strongest support for management’s estimate of allowance for doubtful debts?
- Name two control deficiencies that might result in an understated allowance for doubtful debts.
Introduction
Revenue and receivables are often material in financial statements. IFRS 9 requires receivables to be measured at amortised cost, net of an allowance for doubtful debts—amounts not expected to be collected. The correct recognition and measurement of this allowance are essential for the financial statements to present a true and fair view. For the auditor, understanding the risks of material misstatement relating to receivables is critical, especially as errors commonly arise from failure to identify or provide for uncollectible debts.
Key Term: Allowance for doubtful debts
An estimate of the amount of receivables that may not be collected, recorded to reflect expected credit losses at the reporting date.
Audit Risks Over Receivables and Allowance
Receivables are subject to several significant audit risks—mainly the risk of overstatement due to irrecoverable debts not being provided for. When the allowance is understated, the receivables balance and profit are both overstated.
Common sources of risk include:
- Inadequate credit control policies.
- Incomplete or biased assessment of collectability.
- Failure to update the allowance in line with changes in economic conditions or customer payment patterns.
Key Term: Expected credit losses
The weighted average of credit losses with the respective risks of a default occurring as the weights, as required under IFRS 9.
Assertions Relevant to Receivables
When auditing receivables, the primary assertions at risk are:
- Valuation and allocation: Are receivables stated at an amount expected to be received?
- Existence: Do the reported balances actually exist and are they owed at the period end?
- Completeness: Have all necessary allowances and write-offs been properly recognised?
Key Term: Valuation and allocation
The assertion that assets, liabilities, and equity interests are included in the financial statements at appropriate amounts, and resulting adjustments are correctly recorded.
Recognition and Measurement of Allowance
The allowance for doubtful debts should be based on an objective assessment of the recoverability of receivables at the reporting date. Under IFRS 9, entities must recognise expected credit losses even if there is no objective evidence of impairment.
Typical approaches include:
- Reviewing the aged receivables analysis to identify old or disputed balances.
- Assessing customers with known financial difficulties.
- Evaluating historical collection patterns and specific information known to the client.
Management should regularly review and update their estimate using all reasonable and supportable information, including recent trends and forward-looking economic conditions.
Worked Example 1.1
A company’s aged receivables listing includes $30,000 outstanding from Customer X, all over 180 days old, with little recent payment activity. The company proposes no allowance, stating that Customer X “has been a good client in the past.”
Question: Is this appropriate, and what should the auditor do?
Answer:
The lack of recent payments and age of the debt indicate collection is doubtful. The company should consider an allowance unless evidence shows payment will be received soon. The auditor should test after-date receipts, review correspondence with Customer X, and challenge management’s assumptions if the allowance appears understated.
Substantive Audit Procedures for Allowance
To obtain sufficient, appropriate audit evidence, you should:
- Obtain an aged receivables analysis and investigate material/old balances.
- Review cash receipts after the period end to identify debts subsequently collected.
- Discuss balances in dispute or long overdue with management and credit control staff.
- Compare historical write-off experience and allowance estimates.
- Review correspondence with customers for evidence of disputes, insolvency, or payment plans.
- Inspect board minutes for decisions on debt write-offs.
- Recalculate the allowance and compare with prior periods and industry trends.
Worked Example 1.2
You identify from your audit client’s records that 10% of its receivables are over 120 days old. Last year, the allowance covered all amounts over 90 days. This year, management proposes only 5% of over-120-day balances as doubtful, arguing “economic conditions have improved.”
Question: What is your response as the auditor?
Answer:
Evaluate if the change reflects objective evidence. If economic improvement is not supported by data, and balances remain overdue, management’s estimate may be too optimistic. The auditor should seek supporting evidence, review collection data since year end, and challenge the rationale if inconsistent with observable facts.
Controls Over Allowance and Credit Risk
Effective internal controls are essential for accurate estimation of doubtful debts. Key controls include:
- Timely review and approval of aged receivables listings.
- Clear policies for identifying overdue or disputed balances.
- Monitoring customer credit limits and payment performance.
- Regular updating of the allowance using objective data.
Control deficiencies—such as lack of review, inconsistent policy application, or inadequate tracking of debts—often lead to misstatement.
Revision Tip
Check that the client’s policy for doubtful debt allowance reflects recent payment patterns and not just past experience.
Impact on the Financial Statements
An understated allowance for doubtful debts results in:
- Overstated receivables (current assets).
- Overstated profit for the year.
- Potential understatement of future bad debt expenses.
Key Term: Bad debt expense
The portion of receivables written off or provided for as uncollectible in the period.
Reporting and Disclosure
Receivables should be presented net of the allowance. The amount of the allowance, the accounting policy, and significant judgments used in calculating it must be disclosed in the notes to the financial statements.
Exam Warning
Make sure to distinguish between specific and general (collective) allowances. Also, never treat write-offs and new allowances in the same way for audit purposes—test each separately.
Summary
The estimation of allowance for doubtful debts requires careful assessment of recoverability, robust controls, and regular review. Auditors must design substantive procedures addressing valuation, existence, and completeness, with particular focus on aged, disputed, and high-risk balances. Audit evidence should be persuasive, and management’s judgment must be objectively challenged where necessary.
Key Point Checklist
This article has covered the following key knowledge points:
- State the purpose and impact of an allowance for doubtful debts in financial statements.
- Explain recognition and measurement rules under IFRS 9 for expected credit losses.
- Identify audit risks and assertions relevant to receivables.
- List and explain substantive audit procedures for reviewing the allowance.
- Describe internal control procedures supporting accurate estimation.
- Recognise financial statement consequences of an understated or overstated allowance.
- Outline basic disclosure requirements for the allowance and related policies.
Key Terms and Concepts
- Allowance for doubtful debts
- Expected credit losses
- Valuation and allocation
- Bad debt expense