Provisions and estimates - Allowances for receivables and in...

Learning Outcomes

After reading this article, you will be able to identify the difference between irrecoverable and doubtful debts, explain how to calculate and record allowances for receivables, describe the process for writing down inventory, and apply the concept of prudence in making accounting estimates. You will also be able to demonstrate the impact of these provisions and estimates on financial statements for the ACCA FA2 exam.

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand the treatment of provisions and estimates relating to receivables and inventory. Ensure you focus your revision on the following syllabus points:

• Explain and identify examples of receivables, payables, and provisions.
• Prepare journal entries to write off irrecoverable debts and adjust allowances for receivables.
• Account for and report provisions and liabilities, including inventory write-downs, in accordance with the prudence concept.
• Calculate and apply adjustments for allowances for receivables and inventory write-downs in financial statements.
• Understand the effect of these estimates on reported profit, assets, and capital.

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.

1. Which accounting concept requires a cautious approach so that assets are not overstated and losses are not understated?
   1. Going concern
   2. Accruals
   3. Prudence
   4. Consistency
2. When should a business create an allowance for receivables?
   1. Only when a debt is confirmed as irrecoverable
   2. When there is doubt about collecting amounts owed
   3. For all receivables every period
   4. When an invoice is first issued

3. True or false? Inventory must always be valued at cost, regardless of its current market value or condition.

4. Briefly explain the effect on the statement of profit or loss if inventory is written down below cost.

Introduction

Provisions and estimates are necessary to report a true and fair view of an entity's position. Two frequent areas where estimates are required are allowances for receivables (amounts due from customers) and inventory write-downs. Both adjustments rely on the principle of prudence, which requires anticipated losses to be recognised as soon as they can be measured, whereas profits are only recognised when earned.

This article explains why and how to create an allowance for doubtful receivables, when to write off an irrecoverable debt, and how to value inventory at the lower of cost and net realisable value. You will learn the journal entries needed, how these adjustments affect financial statements, and the rationale behind these practices.

Key Term: provision
An estimated liability of uncertain amount or timing, recognised in the books when there is a present obligation and a probable future outflow of resources.

Key Term: estimate
An informed judgement about the value of an item in the absence of complete certainty, used where exact amounts are unknown at the reporting date.

Key Term: allowance for receivables
A credit balance that reduces the stated amount of trade receivables to reflect amounts that are doubtful to be collected.

Key Term: prudence
The accounting concept requiring caution so that assets and profits are not overstated, and losses and liabilities are not understated.

Key Term: inventory write-down
The adjustment to the carrying value of inventory when its net realisable value falls below cost.

Provisions and Allowances for Receivables

Many entities sell to customers on credit. While most customers pay, some do not. Estimates must be made regarding which receivables may not be recovered in full.

Irrecoverable Debts

When the payment from a customer is definitely uncollectable — for instance, when a customer is declared bankrupt or cannot be traced — the debt should be written off.

Key Term: irrecoverable debt
A receivable that is considered certain not to be collected and is written off as an expense.

Accounting entry to write off an irrecoverable debt

• Debit: Irrecoverable debts expense
• Credit: Trade receivables

This reduces both receivables (in the statement of financial position) and profit (in the statement of profit or loss).

Allowance for Receivables

Where recovery is uncertain but not completely hopeless, an allowance is made for doubtful debts. This is an estimate of amounts at risk, not yet written off. The allowance is reviewed at the end of each period.

Two types of allowance

• Specific allowance: Made for individual customers known to be in difficulty.
• General allowance: Based on a percentage of the receivables balance, reflecting past experience.

Accounting entry to increase the allowance

• Debit: Irrecoverable debts expense
• Credit: Allowance for receivables

If the allowance is reduced, reverse the entry.

Reporting

• The allowance is subtracted from gross receivables in the statement of financial position, showing only the net amount expected to be collected.

Revision Tip Regularly review aged debtor reports to identify customers who may require a specific allowance or should be written off as irrecoverable.

Worked Example 1.1

At 31 December, a business has trade receivables of $20,000. Management identifies $500 as irrecoverable and needs to write it off. They also wish to recognise an allowance of $1,200 for doubtful debts. What are the journal entries, and what amounts are shown in the financial statements?

Answer:

• Write off irrecoverable debt:
  Debit: Irrecoverable debts expense $500
  Credit: Trade receivables $500
• Increase allowance for doubtful debts:
  Debit: Irrecoverable debts expense $1,200
  Credit: Allowance for receivables $1,200
• In the statement of financial position:
  Trade receivables $19,500 ($20,000 - $500 written off),
  Less allowance $1,200
  Net receivables reported: $18,300.

Exam Warning

ACCA exams may ask for the effect of changes in allowance on both profit and the receivables figure. Remember, only the movement in the allowance for the period is charged to profit or loss.

Inventory Write-downs and the Prudence Concept

Inventory is usually valued at cost. The prudence concept requires inventory to be written down if its net realisable value (NRV) is lower than cost. This recognises a loss in the period it becomes foreseen.

Key Term: net realisable value
The estimated selling price of inventory in the ordinary course of business, less any costs of completion and costs necessary to make the sale.

Valuing Inventory at the Lower of Cost and NRV

For each item or category of inventory, compare cost and NRV:

• If cost ≤ NRV: Value at cost.
• If NRV < cost: Value at NRV (write-down required).

Accounting entry for inventory write-down

• Debit: Inventory write-down expense (included in cost of sales)
• Credit: Inventory

This adjustment appears in both the statement of profit or loss and statement of financial position.

Worked Example 1.2

A retailer has an item in stock which cost $200 but is now damaged. It can only be sold for $160 after spending $10 on repairs and $10 delivery. How should it be valued at year-end?

Answer:
NRV = $160 (sales price) - $10 (repair) - $10 (delivery) = $140
Compare cost $200 and NRV $140.
Value in the financial statements = $140 (a write-down of $60 recognised as an expense).

Revision Tip

To avoid errors, always calculate net realisable value carefully, deducting all costs to completion and selling. Do not use sales price alone.

The Impact of Provisions and Estimates

Provisions for doubtful debts and inventory write-downs reduce the reported value of assets and profit. The main purpose is to present a realistic financial position to users.

• Understating an allowance overstates assets and profit.
• Overstating an allowance understates assets and profit.

Worked Example 1.3

The previous allowance for receivables was $2,000. This year management estimates $1,500 is needed. What is the effect on profit for the year?

Answer:
The allowance decreases by $500 ($2,000 – $1,500).
The journal entry is:
Debit: Allowance for receivables $500
Credit: Irrecoverable debts expense $500
This reduces the expense in the current year, increasing profit.

Summary

Estimates for irrecoverable and doubtful debts and inventory write-downs ensure reported assets are not overstated. Only expected recoverable receivables are shown. Inventory is always valued at the lower of cost and net realisable value. All such estimates apply the prudence concept: losses are recognised when probable, but profits only when certain.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and distinguish irrecoverable debts and allowance for receivables
• Record journal entries for writing off irrecoverable debts and adjusting allowances
• Apply the prudence concept in preparing provisions and estimates
• Value inventory at the lower of cost and net realisable value, including write-downs
• Recognise the financial statement effects of these provisions and estimates

Key Terms and Concepts

• provision
• estimate
• allowance for receivables
• prudence
• inventory write-down
• irrecoverable debt
• net realisable value