## **Learning Outcomes**

After reading this article, you will be able to explain the purpose of the allowance for doubtful debts, distinguish between irrecoverable and doubtful debts, calculate and record adjustments to the allowance for doubtful debts, and correctly present related amounts in the statement of profit or loss and the statement of financial position.

## **ACCA Maintaining Financial Records (FA2) Syllabus**

For ACCA Maintaining Financial Records (FA2), you are required to understand the treatment and adjustment of receivables, specifically:

- The distinction between irrecoverable debts and doubtful debts.
- The purpose and calculation of an allowance for doubtful debts.
- Preparing journal entries to create or adjust an allowance for doubtful debts.
- Reporting the allowance for doubtful debts and associated expenses in the financial statements.
- Explaining how changes in allowances affect reported profit and assets.

## **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 that an allowance be made for debts that may not be collected?
   a) Accruals
   b) Prudence
   c) Going concern
   d) Consistency

2. True or false? An increase in the allowance for doubtful debts will increase reported profit.

3. What is the correct double-entry to increase the allowance for doubtful debts by \$1,200 at the year-end?

4. How should the allowance for doubtful debts be presented in the statement of financial position?

## **Introduction**

When a business sells goods or services on credit, it is not always certain that all customers will pay the amounts owed. Some receivables may become irrecoverable, while for others there may be a risk that payment will not be received. To comply with the prudence concept, a business must anticipate such potential losses by maintaining an allowance for doubtful debts.

This article explains the reasons for using an allowance for doubtful debts, demonstrates how to calculate and record changes in this allowance, and shows how these adjustments affect the financial statements. This is an important topic for ACCA FA2 as adjustments for doubtful debts are commonly examined.

> **Key Term: trade receivable**
> An amount due to the business from a customer who has purchased goods or services on credit.
>
> **Key Term: irrecoverable debt**
> A receivable that is considered certain not to be collected and is written off as an expense.
>
> **Key Term: doubtful debt**
> A receivable where there is uncertainty about collection, but it is not yet written off.
>
> **Key Term: allowance for doubtful debts**
> A provision set up in the accounts to reflect the estimated amount of receivables not expected to be collected. The allowance is netted off trade receivables in the statement of financial position.

## **Allowance for Doubtful Debts: Principles and Purpose**

When there is doubt about the collectability of some trade receivables, but the debt is not yet written off, a business should create an allowance for doubtful debts. This aligns with the prudence concept, which requires recognising anticipated losses but not anticipated gains.

Setting up or adjusting an allowance ensures that the statement of financial position does not overstate the asset value of receivables, and provides a more realistic view of expected cash inflows.

The adjustment required each period is based on a review of outstanding receivables, considering any indicators that amounts may not be collected (such as overdue invoices or known customer financial difficulties).

### **Accounting for the Allowance**

At each period end, the allowance account is reviewed and adjusted to match the estimated doubtful debts. The required adjustment is the difference between the opening allowance and the new required allowance at the reporting date.

- If the allowance increases:
  - Debit Irrecoverable Debts Expense (statement of profit or loss)
  - Credit Allowance for Doubtful Debts

- If the allowance decreases:
  - Debit Allowance for Doubtful Debts
  - Credit Irrecoverable Debts Expense

The closing allowance is presented as a deduction from trade receivables in the statement of financial position.

### **Worked Example 1.1**

A business has the following information at 31 December:

- Trade receivables: \$40,000
- Allowance for doubtful debts at 1 January: \$1,500
- Review at the year-end indicates that \$2,300 is required as an allowance.

What is the adjustment required and what is the effect on profit?

> **Answer:**
> Allowance required = \$2,300; Opening allowance = \$1,500; Increase = \$800.
> The adjustment is:
>
> - Debit Irrecoverable Debts Expense \$800,
> - Credit Allowance for Doubtful Debts \$800.
>   This \$800 will be shown as an expense, reducing profit for the year. Trade receivables on the statement of financial position will be presented as \$40,000 less \$2,300.

### **Worked Example 1.2**

Suppose that in the next year, after review, only \$1,000 is required as an allowance, and the opening balance is \$2,300. What is the required adjustment?

> **Answer:**
> Allowance required = \$1,000; Opening allowance = \$2,300; Decrease = \$1,300.
> The adjustment is:
>
> - Debit Allowance for Doubtful Debts \$1,300,
> - Credit Irrecoverable Debts Expense \$1,300.
>   This reduces expenses and increases profit by \$1,300. Trade receivables will be deducted by \$1,000 at year-end.

### **How the Allowance Affects the Financial Statements**

- The current period's irrecoverable debts expense (in the statement of profit or loss) will include both any debts actually written off in the year and any increase (or deduct any decrease) in the allowance for doubtful debts.
- Trade receivables are shown **net** of the allowance in the statement of financial position.

> **Key Term: irrecoverable debts expense**
> The total charge to the statement of profit or loss in the period, which includes actual bad debts written off and net movement in the allowance for doubtful debts.

### **Reporting Format**

**Statement of Profit or Loss:**

Revenue $xx,xxx
Cost of sales (xx,xxx)
Gross profit $xx,xxx
Other expenses (inc. bad debts/allowance) (x,xxx)
Net profit $x,xxx
**Statement of Financial Position (extract):**

Current assets:
Trade receivables $xx,xxx
Less: Allowance (x,xxx)
$xx,xxx

### **Worked Example 1.3**

During the year ending 31 December, a business writes off \$500 of receivables as irrecoverable. The opening allowance for doubtful debts is \$600. The closing allowance required at 31 December is \$1,000. What total expense is charged to profit or loss related to receivables?

> **Answer:**
> Movement in allowance = \$1,000 – \$600 = \$400 (increase)
> Total irrecoverable debts expense = Bad debts written off \$500 + Increase in allowance \$400 = \$900.
> This \$900 is charged as an expense. In the statement of financial position, trade receivables are shown net of the \$1,000 closing allowance.

### **Exam Warning**

> Examiners frequently check whether students adjust for the **movement** in the allowance, not just the closing balance. Always calculate the period's expense as the actual write-off **plus** any increase (or minus any decrease) in the allowance.

### **Revision Tip**

> Always clearly label workings in exam answers: opening allowance, closing allowance, increase/decrease, and the impact on both financial statements.

## **Summary**

Creating and adjusting an allowance for doubtful debts is essential to ensure receivables are not overstated and that potential losses are recorded promptly. For the ACCA FA2 exam, you must be able to distinguish between irrecoverable and doubtful debts, compute the allowance required, prepare the necessary journal entries, and present the information correctly in the financial statements.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define and distinguish between trade receivables, irrecoverable debts, and doubtful debts.
- Explain the purpose of the allowance for doubtful debts and the prudence concept.
- Calculate the movement required in an allowance for doubtful debts.
- Prepare correct journal entries for increasing or decreasing the allowance.
- Present the allowance and related expenses in both the statement of profit or loss and statement of financial position.
- Be aware of common exam pitfalls with allowance calculations.

## **Key Terms and Concepts**

- trade receivable
- irrecoverable debt
- doubtful debt
- allowance for doubtful debts
- irrecoverable debts expense

Receivables adjustments - Allowance for doubtful debts