Irrecoverable Debts

An irrecoverable debt occurs when a business is unable to receive payment from a credit customer for the amount they owe

• The customer might have declared bankruptcy

• The business might no longer be able to contact the customer

Irrecoverable debts used to be referred to as bad debts

Irrecoverable debts are written off by the business, as it is unlikely to receive these amounts

Irrecoverable debts are written off in order to follow the accounting principle of prudence

• Writing off irrecoverable debts reduces the amount owed by trade receivables

• As a result, assets are not overstated

A business will try to collect as much of the amount owed by the customer as possible before writing the debt off

Irrecoverable debt is an expense to the business

• It reduces the profit for the year

Credit the relevant trade receivables account in the sales ledger

• The amount they owe is decreasing

 Debit the irrecoverable debts account in the nominal ledger

• This is an expense

The book of prime entry for irrecoverable debts written off is the journal

Ideally, a business does not want to write off any debts

A business can prevent irrecoverable debts by:

• Setting a credit limit for credit customers

  • This is a limit to how much a customer can owe at any time

• Performing credit checks on potential new customers

  • This is useful if customers want to purchase a lot of goods

• Communicating regularly with credit customers

  • Sending regular statements of accounts

  • Sending emails and calling customers to remind them of their balances

• Taking legal action against customers who fail to pay for their goods

  • This is usually a last resort

  • This will cost the business so sometimes it will not be worthwhile if the debt is less than the legal fee

It is possible that a business receives a payment from a customer for a debt that has already been written off

• The payment could be for the full amount or part of the amount

This can happen if:

• The business manages to contact the customer

• The customer makes an unexpected payment

• The money is retrieved using debt collection services

The book of prime entry for the recovery of debts written off is the cash book

There are two methods for recording the recovery of debts written off

One method is usually used if the recovery occurs within the same financial period as the debts being written off

• The debt is added back to the relevant trade receivables account

  • Debit the trade receivables account in the sales ledger with the amount received

  • Credit the debts recovered account

• The payment then is recorded as normal

  • Debit the cash or bank account

  • Credit the trade receivables account

The other method is usually used if the debt was written off in a previous financial period

• The sales ledger is not used

  • Debit the cash or bank account

  • Credit the debts recovered account

Recovery of debts written off increases profit for the year

• It can be treated as an income to the business

There are two options for dealing with debts recovered at the end of the year

• The balance in the debts recovered account is transferred to the irrecoverable debts account to reduce that balance

  • This reduced balance is then transferred as an expense to the income statement

  • This method is usually used if the recovery occurs within the same financial period as the debts being written off

• Or the balance in the debts recovered account is transferred as an income directly to the income statement

  • This method is usually used if the debt was written off in a different financial period

  • This method is also used if the balance in the debts recovered account is bigger than the balance in the irrecoverable debts account