Allowance for Irrecoverable Debts (Cambridge (CIE) IGCSE Accounting): Revision Note

Allowance for irrecoverable debts

What is an allowance for irrecoverable debts?

• An allowance for irrecoverable debts is an estimation for the amount of sales in a given financial period which will result in irrecoverable debts

• The amount for the allowance for irrecoverable debts can be determined using different methods

  • It could be a fixed percentage of the trade receivables at the end of a financial period

  • It could be a fixed amount based on data from previous years

  • It could factor in how long debts have been outstanding

  • It could be based on which individuals are unlikely to settle their debts

• A business should use the same method for accounting for the allowance each year

  • This adheres to the accounting principle of consistency

• An allowance for irrecoverable debts is similar to a provision for depreciation of a non-current asset

  • The allowance for irrecoverable debts estimates a reduction in an asset

    • The asset is the amount owed by trade receivables

  • However, the reduction is kept in an allowance account which is separate from the asset accounts

Why do businesses set up allowance for irrecoverable debts?

• Businesses use an allowance for irrecoverable debts to adhere to the accounting principles:

  • Prudence

  • Matching

• The principle of prudence is applied because:

  • The assets are not overstated

    • The allowance reduces the trade receivables by a realistic amount

  • The profit for the year is not overstated

    • The potential losses are factored into the expenses

• The principle of matching is applied because:

  • An estimate of irrecoverable debts is made based on sales in a given period

  • This estimate is then treated as an expense for the same period as the original sales

How do I set up an allowance for irrecoverable debts?

• The allowance is set up at the end of the financial period

• The business estimates the amount of sales in that period that will result in irrecoverable debts

  • This is normally a percentage of the trade receivables at the end of the financial period

• This amount is debited to the statement of profit or loss as an expense

  • A credit entry is made in the allowance for irrecoverable debts account

• The balance of an allowance for irrecoverable debts account will be on the credit side because it represents a reduction in an asset

Adjustments to an allowance for irrecoverable debts

How do I update an allowance for irrecoverable debts at the end of a financial period?

• The allowance for irrecoverable debts is reviewed at the end of each year and the amount might be updated

• At the end of the financial period

  • Calculate the new allowance for irrecoverable debts

  • This will be the opening balance of the allowance for irrecoverable debts account for the next financial period

    • Enter it on the credit side 

  • Enter the corresponding closing balance on the debit side of the allowance for irrecoverable debts account for the current financial period

  • Calculate the difference and enter it on the appropriate side to make the account balance

    • This value will be transferred to the statement of profit or loss

• If the allowance for irrecoverable debts increases:

  • The difference will be on the credit side

  • This will be debited to the statement of profit or loss as an expense

• If the allowance for irrecoverable debts decreases:

  • The difference will be on the debit side

  • This will be credited to the statement of profit or loss as an income

How does an allowance for irrecoverable debts affect the financial statements?

• At the end of a financial period, the balance from the allowance for irrecoverable debts account appears on the statement of financial position

  • It is listed under trade receivables

  • The balance is subtracted from the balance for trade receivables

• The difference in the allowance between the start of the year and the end of the year appears on the statement of profit or loss

  • If the allowance has increased, it appears with the other expenses

  • If the allowance has decreased, it appears with the other income