A customer buys goods from a business on credit. This generates sales for the business, which results in a receivable balance.
Since the customer only pays in the future, there is a debit balance in the Receivables ledger account at the point of sale. It is shown as a current asset in the Statement of Financial Position, as the debt is expected to be settled within the next 12 months
- The business records the credit sale by debiting the Receivables account and crediting the Sales account with the amount the customer owes
- When the customer pays the balance owed, the business will debit the Bank account and credit the Receivables account by the amount paid to the business
When a business is owed money, this gives rise to a Receivable balance. Receivable balances are split into Trade Receivables and Other Receivables.
- TRADE RECEIVABLES - a business may sell goods to its customers on credit. the amount the credit customer owes to the business is the Trade Receivables balance.
- OTHER RECEIVABLES - Other Receivables arise from situations where a business is owed money but not from regular trading - for example, loans provided to employees or advances paid to directors.
Payables
A supplier sells goods to a business on credit - the business purchase results in a payable balance.
Since the business only pays the amount owing to the credit supplier in the future, there is a credit balance in the Payables ledger account at the point of purchase.
This is a current liability in the Statement of Financial Position, as the business expects to make payment within a year
- A business records the credit purchase of goods or non-current assets by debiting the Purchase Expenses account or Non-Current Asset account and crediting the Payables account by the amount owed to the supplier.
- When the business pays the amount owed, it will debit the Payables account and credit the Bank account with the amount paid by the business.
When a business owes money, this gives rise to a Payable balance. Payable balances are split into Trade Payables and Other Payables.
- TRADE PAYABLES - A business may purchase goods from its suppliers on credit. The amount owed to the credit suppliers is the Trade Payables balance
- OTHER PAYABLES - arise when a business owes money, not due to regular trading. For example, amounts owed to the tax authority
Trade Receivables and Trade Payables Contra
A business may have transactions with another entity as a customer and a supplier. In this case, a CONTRA entry can be made to reduce the amount outstanding in the business’s Trade Receivables and Trade Payables ledger.
The double entry to book the contra adjustment is as follows:
Dr Trade Payables, Payables (Liability) decreased
Cr, Trade Receivables, Receivables (asset) decreased
Once the contra entry takes place, only the difference is reflected in the Trade Receivables or Trade Payables account
(see example)
What is an Irrecoverable Debt
- is a debt from a customer that is not expected to be recovered
It is money that the business will not receive to settle a receivable balance.
When a credit sale is made, receivables are recognised in the ledger accounts as amounts owed to the business. Irrecoverable debts arise when customers are unable or refuse to pay their debt due to bankruptcy or other financial difficulties.
A business needs to account for three aspects of irrecoverable debt:
-> Irrecoverable debt write off
The balance owed by the customer who cannot pay is an irrecoverable debt. The accounting treatment for irrecoverable debt is to write off the balance from the receivable ledger accounts.
-> Irrecoverable debt subsequent recovery
Suppose the customer subsequently makes payment in part or full of the balances written off. In that case, the accounting treatment is to record the cash receipt and reverse the irrecoverable debt write-off.
-> Allowances for irrecoverable debt
If there are doubts about a credit customer’s ability to make payment for balances owed, an allowance for receivables is recorded.
Irrecoverable Debt Write Off
Irrecoverable debts are balances owed by customers that are not collectable due to the following:
- Credit customers facing financial difficulties
- Credit customer declared bankrupt
- Dishonesty or fraud by the customer
- Credit customers from foreign countries are prevented from making payments due to local government restrictions
Accounting for Irrecoverable Debt Write Off
Once the irrecoverable debt amount is established, the amount is written off to the Statement of Profit or Loss as an expense.
The irrecoverable debt written off affects two ledger accounts:
- Irrecoverable Debt Account (Dr, irrecoverable debt (Expense) increased
- Receivables account (Cr, receivables (Asset) decreased
Receivables are credited (reduced) to reflect that the amount owed to the business is uncollectable. The loss of receipt is charged off to the Statement of Profit or Loss as an expense by debiting the Irrecoverable Debt account.
Irrecoverable Debt Recovery
An irrecoverable debt written off as an expense may be recovered in part or whole.
The payment made by the credit customer is accounted for by reversing the original irrecoverable debt write-off and posting the receipt of payment.
In such cases, the business should question whether it was too hasty in writing the receivable off in the first place and review its writing-off procedures generally.
Accounting for Irrecoverable Debt Recovery
Balances written off may be subsequently recovered. There are two steps to account for this recovery:
- Reverse the irrecoverable debt write-off
- Record receipt by credit customer
Step 1: Reverse the irrecoverable debt write-off
Reversing the irrecoverable debt adjustment affects two ledger accounts:
- Receivables (Dr, receivables (asset) increased
- Irrecoverable Debt (Cr, irrecoverable debt (expense) decreased
Since the balance owed has been paid, the amount is not irrecoverable. Therefore, an adjustment to reverse the earlier write-off is made.
Step 2: Record the receipt
The receipt made by the credit customer affects two ledger accounts:
- Bank (Dr, Bank (asset) increased
- Receivables (Cr, receivables (asset) decreased
Allowance for Receivables
Allowance for Receivables is recorded when a business is unsure whether debts will be paid. The business can adjust for these balances when uncertain by reducing the receivables balance. This Adjustment is known as the allowance for Receivables.
At the end of each year, businesses will review all customer accounts in the receivables ledger and identify if an allowance needs to be made for the balance owed that may not be settled.
The outcome of the review includes:
- The business identifies customers where there is evidence that they WILL NOT PAY. eg. the customer is filing for bankruptcy. These customer balances should be written off as irrecoverable debts
- the business identifies customers with evidence to suggest they MIGHT NOT PAY. for example, a customer has a balance outstanding of more than 180 days.
An allowance for receivables is set for these account balances. This allowance for receivables is a form of SPECIFIC ALLOWANCE. - The business may take an allowance for receivables based on an ESTIMATED PERCENTAGE of debts that are expected to be irrecoverable. For example, the history of a business shows that 4% of debts become irrecoverable. This estimate is based on past knowledge and experience and is calculated as a percentage of the total receivable amount. This allowance for receivables is a form of GENERAL ALLOWANCE.
Presentation in Financial Statements
The allowance for receivables is recorded in a separate ledger account in the general ledger. This allowance is reflected as a credit entry in the Allowance for Receivable account in the Statement of Financial Position and is deducted from the Trade Receivables balance.
After deducting the allowance for receivables, the Trade Receivables account reflects the amount the business expects to collect from customers.
Current Assets:
Trade Receivables X
Less: Allowance for Receivables (X)
———————————————-
x
Accounting for Allowance for Receivables
At the end of each accounting period, the business reviews its customer accounts and identifies customers with evidence to suggest they might not pay. The business will also make a general estimate of the percentage of receivables expected to be irrecoverable.
The steps needed to account for the Allowance for Receivables are:
- Calculate the closing allowance for the receivables balance at the year-end
- Calculate the difference between the closing allowance for receivables and the opening allowance for receivables.
- The increase or decrease is adjusted in the Allowance for Receivables ledger account to reflect the closing allowance for receivables.
The increase or decrease between the closing and opening allowance is posted to these two ledger accounts via the Journal:
- Irrecoverable Debt account
- Allowance for Receivables account
If the current allowance calculated is MORE than the opening allowance balance
Dr, Irrecoverable Debt, irrecoverable debt (expense) increased
Cr, Allowance for Receivables , Receivables (Asset) decreased
Since it has been identified that the closing allowance is more than the opening allowance, the difference is posted as an expense under Irrecoverable Debt in the Statement of Profit or Loss.
If the current allowance calculated is LESS than the opening allowance balance,
Dr, Allowance for Receivables, Receivables (Asset) increased
Cr, Irrecoverable Debt, Irrecoverable debt (Expense) decreased
Since the closing allowance is less than the opening allowance, the difference is posted to decrease the irrecoverable debt expense. The reduced expense will be shown in the Statement of Profit or Loss.
(see example)
Liabilities
Definition - A liability is a present obligation of the entity to transfer an economic resource as a result of past events
In essence, a liability is an amount the business owes, resulting in future outflow (or payment) of money.
Liabilities can be classified into:
- Non-Current Liabilities – Amounts owed that will be paid after more than one year
- Current Liabilities – Amounts owed that will be paid in less than a year
Liabilities are amounts that are owed by the business to suppliers of goods, banks, authorities and other lenders. A credit entry is posted into the relevant liability ledger accounts to record a liability.
Provisions - a liability of uncertain timing or amount
IAS 37 Provisions, Contingent Liabilities and Contingent Assets define a provision as a liability of uncertain timing or amount.
A liability is an amount owed by a business to another entity, such as suppliers or the government. For most liabilities, the amount owed is known.
For example, the amount of sales tax owed to the tax authority is taken from the Sales Tax account. Similarly, the amount of trade payables is known because the Payables ledger and relevant invoices support it.
However, the timing and amount that has to be paid are uncertain for some liabilities. A provision adjustment is created in such situations.
Examples of situations where provision adjustments are required are:
- A shop has a refund policy that is made known to customers, and past evidence shows that a certain number of customers always return their goods. The business should recognise a provision at year-end for the estimated returned goods.
- Businesses may give warranties or guarantees to cover repairs selling goods. A provision should be recognised on the estimated costs the business needs to pay for the warranties and guarantees using historical data.
- A business has a legal obligation to make good a location that they have damaged or polluted. The estimated cost of repair is recognised as a provision.
- A business has an ongoing legal case against another entity, likely resulting in it having to pay damages or a fine. A provision may be created for the estimated penalty payment of a potential loss.
Recognition of Provisions
IAS 37 Provisions, Contingent Liabilities and Contingent Assets provide the principle rules for the recognition and measurement of Provisions. Clear accounting rules are provided to prevent recognising provisions that are ultimately never paid.
To recognise a provision liability, these criteria must be met:
- The entity has a PRESENT OBLIGATION to make future payments due to past events. An obligation can be either legal or constructive.
-A legal obligation enforceable by law, such as a contract or legislation requirement.
-A constructive obligation means that the business has set up an expectation that they will make payment. The business has indicated that it has accepted specific responsibilities and created a reasonable expectation for other parties to receive compensation.
- It is PROBABLE that a transfer of economic benefit is required to settle the obligation
- A RELIABLE ESTIMATE of the provision can be determined.
In essence, the amount of provision cannot be based on guesswork. There must be some form of evidence to support the value.
Presentation in Financial Statements
Provisions are a liability of uncertain timing or amount. Once a provision meets its recognition criteria, it is recorded in the Provisions account as a credit entry in the Statement of Financial Position.
A provision can be a current or non-current liability, depending on its expected repayment date.
(see statement of financial position structure)
Accounting for Provisions
The steps needed to account for the Provisions are:
1. Calculate the closing provision balance at teh year-end
2. Calculate the difference between the closing and opening provision balance
3. The increase or decrease is adjusted in the Provisions ledger account to reflect the closing Provision amount.
An adjustment for provisions affects two ledger accounts:
- Individual Expense or Asset
- Provision
If the current provision calculated is MORE than the opening provision balance
Dr, Individual expense, individual Expense increased
Cr, Provision Account, provisions (liability) increased
If the current provision calculates is LESS than the opening provision balance
Dr, Provision Account, provisions (liability) decreased
Cr, Individual expense, individual expense decreased
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Chapter 1: Elements of Financial Statements and The Accounting Equation30
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Chapter 2: Maintaining Financial Records27
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Chapter 3: Accounting for Cash and Bank18
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Chapter 4: Credit Sales and Purchases21
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Chapter 5: Sales Tax21
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Chapter 6: Tangible Non-Current Assets35
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Chapter 7: Inventories26
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Chapter 8: Receivables24
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Chapter 9: Accruals, Prepayments, Accrued and Deferred Income25
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Chapter 10: The Trial Balance and Financial Statements43
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Chapter 11: Partnerships21
