Understanding Bad and Doubtful Debts in VCE Accounting

In this blog, we seek to understand how businesses deal with uncertainty around future cash flows from accounts receivable, in a topic called bad and doubtful debts. We then apply this theoretical knowledge to practical examples where businesses account for this uncertainty in their financial reports.

Liquidity is an important aspect of financial performance. In the following worked example, we analyse the trend in liquidity of a business over a two-year period.

One means through which businesses facilitate sales transactions is through credit. Offering customers credit is critical to attracting as many customers as possible, making goods and services accessible to customers who lack the cash to pay for them at the point of sale, or who would otherwise prefer to delay their payment.

This is not without risk, since there is a possibility that some credit customers will be unable to pay what they owe from the sale. This is what is referred to as a bad debt. A customer’s outstanding balance (part of accounts receivable) is now irrecoverable - the business will not collect the outstanding funds. This primarily occurs when a customer is declared bankrupt.

The accrual basis assumption is upheld when the bad debt is incurred in the same period as the relevant credit sale, since the bad debt will be matched with the respective revenue earned from the credit sale in the period.

However, bad debts expenses are not always incurred in the same period as the credit sale took place: this is where an allowance for doubtful debts is important. To uphold accrual basis by ensuring that bad debts expenses are matched with the credit sales revenue earned in the same period, an allowance for doubtful debts must be constructed.

An allowance for doubtful debts is an estimate of debt that is unlikely to be collected in the future. These are debts that have yet to be written off - the inability of some accounts receivable to pay has yet to be announced. Typically, the allowance for doubtful debts is estimated as a percentage of net credit sales.

The allowance for doubtful debts is a negative current asset. The allowance for doubtful debts line item is placed directly beneath accounts receivable in the balance sheet.

The creation of an allowance for doubtful debts causes the business to incur a bad debts expense, which is placed in the other expenses section of the income statement. This results in a decrease in current assets and a decrease in owner’s equity via a lower net profit.

Which Qualitative Characteristics and Assumptions Support the Recording of Bad Debts?

Accrual Basis

The incorporation of the allowance for doubtful debts estimate ensures that the bad debts expense is incurred in the same period that the respective credit sale took place. This upholds the accrual basis assumption, which emphasises the matching of revenues earned with expenses incurred in the same period.

Relevance

Bad debts expenses have a material impact upon decision-making, so reporting them in both the income statement (the bad debts expense) and the balance sheet (the allowance for doubtful debts) is important for decision-making about many aspects including:

• The credit screening of customers, ensuring the right customers are granted access to credit
• The proportion of accounts receivable the business expects are unlikely to be collected as a cash inflow
• Whether the current estimate of the allowance for doubtful debts is reasonable or needs adjustment.

Faithful Representation

The reporting of both the bad debts expense and the allowance for doubtful debts ensures that the business’s financial reports reflect the actual, real-world financial position and performance of the business. The omission of such information would render these reports biased and incomplete.

Two Types of General Journal Entries

There are two commonly recorded transactions in this topic:

1. Write-offs
2. Creating/updating the allowance.

Example

Suppose that for the year ended 30th June 2024, the business made credit sales of $162,000 and sales returns were $2,000. Suppose also that the business has a current allowance for doubtful debts of $3,000 but decides to increase its allowance to 3% of net credit sales.

Record the relevant entry in the general journal.

This question requires us to update the business’s allowance for doubtful debts from $3,000 to its target level of 3% of net credit sales, i.e., from $3,000 to ($162,000 - $2,000) * 0.03 = $4,800. This means the allowance for doubtful debts must increase by $1,800. We record the following:

Now suppose that on 5th July 2024, the business is informed that one of its customers, XYZ, has been declared bankrupt and will be unable to pay the $3,300 including GST they owe our business. To record this in the general journal, we input the following: