💨This topic could most probably come out as part of an adjustment in the 1st question on Profit & loss adjustment or as a question on its own which is pretty rare.
☝Why do a business have trade receivables?
Ans: Trade receivables arise whenever the company makes a credit sales of goods or services to a customer. The customer is given a period to repay the debt. The journal entry are as such:
💨When a business makes a credit sales:
Dr Trade Receivable $XX
Cr Sales Revenue $SS
💨When a business receives payment from a trade receivable:
Dr Cash at bank $XX
Cr Trade Receivable $XX
When a business gives discount to a customer to encourage customer to pay earlier:-
Dr Discount allowed $XX
Dr Cash at bank $XX
Cr Trade Receivable $XX
💨 Impairment of trade receivables
Credit Risk is a risk that exist for any business which sells goods/service on credit to customer. It is the risk of not able to collect partially or wholly the amount owed to the business from the credit customer.
When a debtor cannot pays up, the business will suffer a loss since the goods & services it provided cannot be obtained back. As such, the loss is term : Impairment loss on trade receivables. The loss is recorded in the income statement as such:-
Dr Impairment loss on trade receivable
Cr Allowance for impairment of trade receivable
At the end of each financial period, a business reviews its existing trade receivables and calculate how much it cannot received from customer based on objective evidence.
Some examples of objective evidence are: -
💥1. Despite numerous letters to the debtor, the debtor has not responded or gives excuses for not paying up.
💥2. There are market or same industry news concerning the debtor having financial difficulties.
💥3. The debtor sends a dishonoured cheque which cannot be encash.
Because of the factors above, the business will have to maintain an Allowance for impairment of trade receivable account which is recorded in the balance sheet as below shows:-
💨Recording allowance for impairment for trade receivable
If the business doesn't have an allowance for impairment of trade receivable account, the initial recording will be as such: -
Dr Impairment loss on trade receivable
Cr Allowance for impairment of trade receivable
Lets try some example to understand this concept:-
☝Company ABC has total trade receivables of $10,000 for the financial year ended 31 Dec 2020. The management has reviewed and conclude that out of this $10,000, $3,000 of debt belonging to Company XYZ was deemed irrecoverable and would like to provide for this amount. Company ABC currently does not has an Allowance for impairment of trade receivables account. Prepare the i) Allowance for impairment of trade receivable account and ii) Impairment loss on trade receivable account:-
Ans:
** Note that the journal entry did not touch any Trade receivable account, it was just Allowance account and Impairment loss account !
💨📈Using the previous example of ABC Pte Ltd with Allowance for impairment of trade receivable balance of $3,000 as at 31 Dec 2020, fast forward to 31 Dec 2021, due to the worsening economic condition, the management has determined the trade debtors who are unable to paid up to be $5,000 as at 31 Dec 2021 with the additional $2,000 coming from the debt of Company DEF.
So currently the balance in the allowance for impairment on trade receivable is $3,000 , we need to increase to ------> $5,000 which is an additional $2,000 ($5,000 - $3,000). The journal entry will be as below:
Dr Impairment loss on trade receivable account $2,000
Cr Allowance for impairment of trade receivable acc $2,000
The allowance for impairment of trade receivable account has a balance of $5,000 currently ($3,000 from company XYZ and $2,000 from company DEF) as at 31 Dec 2021. ** Did we adjust trade receivable accounts??? No:)
💨📉using the previous example of ABC Pte Ltd with Allowance for impairment of trade receivable balance of $5,000 as at 31 Dec 2021. Lets fast forward to 2022, lets say this time because of news that DEF company has won a big tender contract and is able to pay off its debt of $2,000, henceforth as at 31 Dec 2022, management reviewed the trade receivable and will want the allowance for impairment to consist of the debt from company XYZ which is $3,000.
Bearing in mind that the balance in allowance for impairment for trade receivable is $5,000 as per prev year adjustment, now that we need to reduce it to $3,000 , prepare the journal entry:-
Reduction of allowance for impairment of trade receivables:-
Dr Allowance for impairment of trade receivable $2,000
Cr Impairment loss on trade receivable account $2,000
** We are so used to seeing Dr impairment loss that once it changes to Cr Impairment loss, we wonder whats is it, its an entry to reduce expenses:)
💨Now, referring to the previous example, as at 31 Dec 2022, our allowance for impairment of trade receivable account balance is $3,000.
Lets say on 1st Feb 2023, DEF Company was declared bankrupt, and was able to pay $2,000 and the remaining $1,000 is to be written off, prepare the entry.
💥 Note that, we have previously provided for DEF allowance in the allowance for impairment of trade receivable account.
Henceforth, we will not be debiting to Impairment loss on Trade Receivable account, instead we will adjust only the Allowance for impairment of Trade Receivable account and Trade Receivable account - DEF Company:-
1st Step - Adjusting for the $2,000 that DEF Company is able to pay :-
Dr Cash at Bank $2,000
Cr Trade Receivable DEF Company $2,000
 |
| Dr Cash at bank $2,000 Cr Trade Receivable $2,000 for receipt of $2,000 |
2nd Step-Write off of debt of $1,000 by DEF Company.
💥Since there are sufficient balance in the Allowance for impairment of trade receivable to adjust, we can avoid touching Impairment loss account.
The journal entry will be as such for the write off: -
Dr Allowance for impairment of trade receivable 1,000
Cr Trade Receivable - DEF Company 1,000
2 Points to note:
💡 DEF Trade receivable account is nil at the end of their settlement and write off.
💡 Had the writeoff belonged to another trade receivable other than DEF Company let say Company TUV, will the writeoff entry still be the same?
Ans: Yes, the writeoff entry Dr Allowance for impairment of trade receivable and Cr Trade Receivable -TUV will still be the same provided the amount being written off is less than the allowance for impairment of trade receivable balance (i.e. lower than $3,000).
Now lets test your understanding by attempting this question:-
💥Note: when trade receivable - Pickachu paid his outstanding debt, no adjustment was made in the Allowance for impairment of trade receivable. Pls note that even though Pickachu was one of the debts which contributed to the allowance for impairment, any payment from Pickachu or other trade debtor should not result in an adjustment in the allowance for impairment unless it is a write-off.
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