8.1 Bad debts written off

A bad debt is an amount owed by a credit customer (a receivable) that the business is satisfied it will never collect. Keeping such an amount in the receivables ledger would overstate both the asset "trade receivables" and the profit for the period, so the debt is removed from the books and charged as an expense in the statement of profit or loss. Writing off a debt is an accounting entry only: the legal right to recover the money remains, and any amount later recovered is brought back into the books. Example: a hardware wholesaler in Turbo writes off Ksh 36,000 owed by a building contractor who has been declared bankrupt.

Meaning of a bad debt

A debt becomes bad when there is objective evidence that it cannot be recovered. The decision is made by management, usually on the recommendation of the credit controller, and should be authorised in writing before the entry is made.

• Insolvency of the customer: The customer has been declared bankrupt or a company customer has been placed in liquidation, and the trustee or liquidator has confirmed that little or nothing will be paid.
• Death without an estate: An individual customer has died and the estate has no assets to settle the debt.
• Customer cannot be traced: The customer has disappeared, left no forwarding address and all reasonable tracing efforts have failed.
• Cost of recovery exceeds the debt: Legal action would cost more than the amount owed, for example suing for a balance of Ksh 4,500 when advocates' fees alone would be higher.
• Time-barred debt: Under the Limitation of Actions Act (Cap 22) an action on a simple contract debt cannot be brought after six years, so a very old unacknowledged debt is effectively unrecoverable.

Accounting entries for writing off a bad debt

The receivable is credited to clear it, and the bad debts expense account is debited.

1. Obtain authority: The credit manager prepares a write-off memo with the customer's details, amount, age of debt and the evidence that it is irrecoverable, and a senior manager approves it.
2. Record in the journal: Debit Bad debts account, Credit the customer's account in the receivables ledger (and the sales ledger control account in the general ledger).
3. Post to the ledgers: The customer's personal account is closed off; the control account is credited with the same amount.
4. Close the bad debts account at year end: Debit Statement of profit or loss, Credit Bad debts account, with the total written off in the year.
5. Keep the file: The write-off memo, correspondence and insolvency notices are filed as evidence for the auditors and for the Kenya Revenue Authority, since a bad debt written off may be deductible for income tax only where KRA's conditions for bad debt deduction are met.

Worked example: partial recovery from an insolvent customer

Kiptoo Traders owed Ksh 48,000. Kiptoo was declared bankrupt and the trustee paid a final dividend of 25 cents in the shilling. The rest is written off.

Amount received = 48,000 × 0.25
= Ksh 12,000

Amount written off = 48,000 − 12,000
= Ksh 36,000

Journal entries:

The customer's account now has a nil balance, and Ksh 36,000 is charged to profit or loss.

Bad debts recovered

Sometimes a customer whose debt was written off later pays all or part of it. The recovery is recorded in two steps so that the customer's account shows the full history, which matters if the business extends credit to that customer again.

1. Reinstate the debt: Debit the customer's account, Credit Bad debts recovered account, with the amount to be paid.
2. Record the cash: Debit Bank (or Cash), Credit the customer's account.
3. Year end: The balance on Bad debts recovered is credited to the statement of profit or loss as other income (or set off against the bad debts expense for the year).

Example: in March a customer whose Ksh 15,000 debt was written off two years earlier pays Ksh 9,000. The entries are Dr Customer 9,000, Cr Bad debts recovered 9,000; then Dr Bank 9,000, Cr Customer 9,000.

Effect on the financial statements

• Statement of profit or loss: Bad debts written off appear as an operating expense, reducing net profit.
• Statement of financial position: Trade receivables are reduced by the amount written off, so the asset is shown at an amount the business expects to collect.
• Control account: The total of bad debts written off is credited to the sales ledger control account so that the control account still agrees with the list of individual receivable balances.
• Prudence: Writing off irrecoverable debts promptly applies the prudence concept: losses are recognised as soon as they are known.
• IFRS 9 link: Under IFRS 9 Financial Instruments a receivable is written off when the entity has no reasonable expectation of recovering it; the write-off is usually charged against any loss allowance already made for that debt.