Bad Debts

What are debts?

The accounts of sole traders show Debtors to the business, i.e. all of those who owe money to the business, each of which is a debtor to the business. In the accounts of partnerships and companies, the debtors are referred to as Receivables and again represents the money that the company is expecting to receive. Because this is money that the business is expecting to receive, the debtors/receivables is an asset account.

What are bad debts?

It is an unfortunate fact of business is that not all debts get paid and this has to be taken into account when preparing financial statements for a business.

A debt becomes a bad debt when the business knows with certainty that it is never going to receive payment of the amount owed. This could be, for example, because the debtor has gone into an insolvency/bankruptcy process. When this happens, the bad debt are written off. The owner of the business gives up any hope of collecting the debt and the debt is therefore removed from the Receivables/Debtors entry in the accounts.

Writing off bad debts

It may become apparent during the accounting year that a debt is never going to be paid and therefore, bad debts may be written off at any time during the accounting year. If they are written off during the accouting year then there will already be a bad debts expense account included in the trial balance. However, the business may also need to carry out a further year-end adjustment as other debts may be written off at the end of the accounting year when a review is performed of the debts that are owed to the business. If it is decided that a further debt needs writing off as a bad debt but the year-end adjustment is not performed, the accounts will not give a true reflection of the position of the business. Instead, it will seem that the business is expecting more money to be paid to it than is actually the case.

Dual effect of Bad debts

The effect of bad debts will be shown in an asset account and an expense account.

• Asset: The receivables asset account will be reduced by the amount of the bad debt, resulting in the receivables account then show the correct balance. This is an adjustment to the balance sheet.
• Expense: An expense account is used as the bad debt is a cost to the business. The business has supplied a product or service and will never be paid for it. This is an adjustment to the profit & loss account.

Example

At the end of its accounting period Jacksons Printers (‘Jacksons’) has a balance on its receivables account of £11,000. At year end it is discovered that one of its trade customers has been declared insolvent, owing Jacksons £550.

The trial balance will show that £11,000 is owing to Jacksons, but they know that £550 of that will never be paid.

The receivables asset account must therefore be reduced to £10,450 (i.e. £11,000 – £450).

The bad debt itself will be shown as part of a ‘bad and doubtful debts’ expense account.