Cambridge IGCSE Accounting · 0452
Chapter 4: Accounting Procedures — Part 5
Sections 4.4 & 4.5 · Irrecoverable Debts, Provision for Doubtful Debts & Valuation of Inventory
Irrecoverable Debts (Bad Debts)
Definition: A debt that a firm is almost certain will not be paid, usually because the debtor has become bankrupt.
Accounting Treatment: To cancel the effect of the sale, the debt must be written off as an expense.
Journal Entry:
- Debit: Irrecoverable Debts Account (Expense).
- Credit: Debtor’s Personal Account (Asset reduced).
Recovery of Debts Written Off
If a debtor pays after the debt has been written off in a previous year, the book-keeping is a two-step process:
- Reinstate the debt: Dr Debtor’s Account, Cr Irrecoverable Debts Recovered Account.
- Record receipt: Dr Cash/Bank, Cr Debtor’s Account.
Worked Example 1: Recovery of Debt Written Off
In 20X7, M. Tan’s debt of $450 was written off: Dr Irrecoverable Debts $450; Cr M. Tan $450.
In 20X8, M. Tan pays $450 in full. The two-step recovery:
- Reinstate the debt: Dr M. Tan $450; Cr Irrecoverable Debts Recovered $450
- Record receipt: Dr Bank $450; Cr M. Tan $450
Irrecoverable Debts Recovered is credited to the Income Statement as other income — it does not reverse the original irrecoverable debts expense of the prior year.
Provision for Doubtful Debts
Definition: An estimate of the amount of Trade Receivables (debtors) at year-end that are unlikely to pay their debts. This follows the Prudence concept by ensuring assets and profits are not overstated.
Accounting for Adjustments:
- Creation/Increase: Dr Income Statement (Expense), Cr Provision for Doubtful Debts Account.
- Decrease: Dr Provision for Doubtful Debts Account, Cr Income Statement (treated as “Other Income”).
SFP Presentation: In the Statement of Financial Position, Trade Receivables are shown less the full closing provision to show their “true” value.
Worked Example 2: Provision Increase and Decrease
Year 1: Trade receivables $40,000; create provision at 5% = $2,000.
Journal: Dr Income Statement $2,000; Cr Provision for Doubtful Debts $2,000.
Year 2: Trade receivables $48,000; provision still 5% = $2,400.
Increase = $2,400 − $2,000 = $400 expense.
Journal: Dr Income Statement $400; Cr Provision for Doubtful Debts $400.
Year 3: Trade receivables $35,000; provision 5% = $1,750.
Decrease = $2,400 − $1,750 = $650 other income.
Journal: Dr Provision for Doubtful Debts $650; Cr Income Statement $650.
SFP Year 3: Trade receivables $35,000 − Provision $1,750 = $33,250.
Valuation of Inventory
Inventory must be valued at the lower of Cost and Net Realisable Value (NRV). This is a strict application of Prudence.
- Cost
- Purchase price plus costs to bring the inventory to its current location (e.g., carriage inwards).
- Net Realisable Value (NRV)
- Estimated selling price minus any costs needed to complete the goods or sell them (e.g., repairs, commission).
Worked Example 3: NRV Calculation
Closing inventory at 31 December:
| Item | Units | Cost ($) | Selling Price ($) | Selling Cost ($) | NRV ($) | Value ($) |
|---|---|---|---|---|---|---|
| Product A | 100 | 8 | 12 | 2 | 10 | 800 |
| Product B | 50 | 15 | 14 | 3 | 11 | 550 |
| Product C | 80 | 6 | 9 | 1 | 8 | 480 |
Product B: NRV $11 < Cost $15, so value at $11 × 50 = $550. Total closing inventory = $800 + $550 + $480 = $1,830.
Impact of Incorrect Valuation
| Valuation Error | Effect on Gross Profit | Effect on Profit for Year | Effect on Assets (SFP) |
|---|---|---|---|
| Overvalued Closing Inventory | Overstated | Overstated | Overstated |
| Undervalued Closing Inventory | Understated | Understated | Understated |
Exam Traps
- Inventory Trap: Examiners often give a list of items where some have NRV lower than cost. You must value each item individually at its lowest value and then sum them up, rather than using the total cost vs. total NRV.
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