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Two methods of bad debts recognition in Account Receivables – ACCA FR/SBR

My name is Steve Chen, a fellow member of ACCA and course director at APC (www.globalapc.com), teaching ACCA online courses to students from all around the world.


In ACCA Financial Accounting papers syllabus, only direct write off method for recognising irrecoverable debt expenses is required. However, there are clear limitations of this method, ie not meeting with ‘matching’ principle. Lots of businesses in the real world would use the second method to recognise irrecoverable debt expenses.



Therefore, this article is supplement to your ACCA FA/FR and SBR studies regarding the recognition of bad debt expenses.


Method one: Direct write off Method:


1. Customer A Will Not Pay the Invoice


Before the Financial Statements year end, customer A sends an email that it has financial difficulties and has declared its bankruptcy. This means customer A is not going to pay us the invoice of $1,600 and certainly, the cash discount was not taken. The following journal entries should be recorded:


When customer A announces its bankruptcy:


Dr Irrecoverable debt expense (statement of profit or loss) $1,600

Cr Accounts receivable $1,600


The irrecoverable debt expense has increased by $1,600 whereas the accounts receivable asset has decreased by $1,600.


2. Customer A Settles the Invoice


After customer A (based in the USA) files its bankruptcy petition according to Chapter 11 of the USA Bankruptcy Code, customer A (business) is protected by the code and allowed to reorganise or improve its business operations. Eventually, customer A becomes profitable again and is able to settle the invoice. Hence when customer A pays, the following journal entry should be made:


Dr Bank $1,600

Cr Irrecoverable debt expense (statement of profit or loss) $1,600


This means that we had recognised the previous $1,600 irrecoverable debt expense because we knew the bad debt may potentially occur. Now, the bad debt will not occur and therefore, the business increased the cash received by debiting $1,600 bank. An increase in asset will also result in an increase in equity, in this case, because we have charged the previous irrecoverable debt expense. Now, we need to reduce this expense by crediting it, and in reducing the expense, the equity will increase. This is how the direct write-off method works.


Please note, when the customer pays us the previously recognised bad debt amount, it has nothing to do with accounts receivable because the accounts receivable has been previously derecognised when the business recognised the irrecoverable debt expense. Therefore, there will be no changes to the accounts receivable.


From the above journal entry, we credited the irrecoverable debt expense. Now, suppose the customer settled the invoice in the second year and we had recognised the irrecoverable debt expense in the first year. Would we credit the irrecoverable debt expense in the second year’s Financial Statements or back in the first year’s Financial Statements?


The answer is to credit the irrecoverable debt expense at the time when we receive the money from the credit customer, i.e., in the second year, not the first. The reason for this is that the Financial Statements are prepared based on the management’s best estimate. In the first year, the management estimated that customer A would not pay due to customer A’s announcement of its bankruptcy, and therefore an expense had been recorded.


In the second year, because the money is paid back by customer A, the expense needs to reduce at this juncture. You can also argue that this approach has a flaw, i.e., the decrease in bad debt expense did not match with its original sales revenue, particularly if the sales revenue and bad debt expense took place in different accounting periods.


Method 2: Allowance (allowance for doubtful debts) Method:


From the above example, if the business has not previously recognised an ‘allowance’ for the accounts receivable, the accounting treatment for the bad debt is exactly the same as before:


Dr Irrecoverable debt expense (statement of profit or loss) $1,600

Cr Accounts receivable $1,600


The subsequent treatment will be the same as before if there is no allowance.


let us look at another case:


The company has three credit transactions: credit sales of $1,000 to customer A, credit sales of $5,000 to customer B, and $7,000 to customer C. No cash discounts are offered to these customers. For ‘prudence’ reasons—the company is very careful not to overstate these receivable balances—the business has prepared the following receivable age analysis for the credit transactions at the Financial Statements year end:



In technical terms, according to IFRS 9 Financial Instruments, the above table is called the ‘provision matrix’.


1. The business needs to first set up the allowance for doubtful debt according to its best estimate regarding the future likely bad debt expense. However, please note, the above $146 allowance for doubtful debts is not a real bad debt, i.e., the business assumes that perhaps only $12,854 may be received. ($13,000 total receivable, subtracting $146 allowance). The following entry is made:


Dr Irrecoverable debt expense (statement of profit or loss) $146

Cr Allowance for doubtful debt (statement of financial position) $146


2. The customer C has announced its bankruptcy and could only settle $6,900 of the invoice (it originally owed us $7,000). Hence, $100 bad debt expense incurred. The following entry is made:


Dr Allowance for doubtful debt (statement of financial position) $100

Cr Accounts receivable (statement of financial position) $100


3. A few days later, the customer C has settled the previously-recognised $100 bad debt. The following journal entry is made:

Step 1: Reverse the above allowance journal:

Dr Accounts receivable (statement of financial position) $100

Cr Allowance for doubtful debt (statement of financial position) $100


Step 2: Record the cash transaction:

Dr Bank (statement of financial position) $100

Cr Accounts receivable (statement of financial position) $100


Let’s recalculate the allowance for doubtful debt, as customer C has now settled the full invoice. Let’s assume that customer A and customer B have not settled their invoices yet:



The allowance for doubtful debt was $146 at the start, and now it has gone down to $55. The following journal entry is made:


Dr Allowance for doubtful debt (statement of financial position) $91

Cr Irrecoverable debt expense (statement of profit or loss) $91


Now, customer D has a $9,000 credit transaction with the business.


The management has revised the accounts receivable aged analysis as follows: (suppose the previous customers A and B have settled their invoices in part of $300 and $2,000 and therefore, they still owe us $700 and $3,000):




The allowance for doubtful debt has now gone up by $153 from $55 to $208. The following journal entry is made for the increase in the allowance for doubtful debt:


Dr Irrecoverable debt expense (statement of profit or loss) $153

Cr Allowance for doubtful debt (statement of financial position) $153


Can you see the differences between the direct write-off and the allowance method? In the second method, (allowance method), the bad debt will be adjusted from the allowance for doubtful debt account but not directly write off the accounts receivable, i.e., the bad debt is written off from the accumulated allowance account. It, therefore, solves the ‘unmatching’ problem as we have seen in the direct write-off method. Under IFRS, both methods are allowed.


In addition to providing ACCA lectures online, I also wrote articles in ACCA AB magazine. Besides, I am the author of four accounting books. If you are interested in studying ACCA courses with me, please visit my website http://www.globalapc.com for further information, where you can find many of my ACCA demo video lectures.


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