Receivables and Payables: Bad Debts, Allowances, and Contras

Learning objectives

By the end of this chapter, you should be able to:

• Record and monitor trade receivables and trade payables using subsidiary ledgers and control-account thinking.
• Write off irrecoverable receivables and record any later recoveries correctly.
• Calculate and adjust an impairment allowance on receivables using both percentage and ageing approaches.
• Record set-off (contra) arrangements between receivables and payables and explain their effect on balances and presentation.
• Explain the impact of write-offs, impairment allowances, and contras on profit or loss, assets, liabilities, equity, and reconciliations.

Overview & key concepts

Receivables and payables arise from credit trading and have a direct effect on working capital and reported performance. If receivables are overstated, profit and assets can be overstated. If payables are misstated, liabilities and cost recognition can be distorted.

This chapter focuses on three areas that regularly appear in assessments:

• Irrecoverable debts (bad debts):specific customer balances that are no longer expected to be collected and must be removed.
• Impairment allowance on receivables:an estimate of expected non-collection, presented as a reduction against receivables.
• Contras (set-offs):agreed netting between amounts due from and due to the same counterparty.

Trade receivables and payables

What they represent

• Trade receivablesarise when goods or services are supplied on credit and payment will be received later.
• Trade payablesarise when goods or services are purchased on credit and will be paid later.

A cash sale does not create a receivable, and a cash purchase does not create a payable. The key trigger is credit.

Subsidiary ledgers and control-account thinking

Receivables and payables are tracked in detail in subsidiary ledgers:

• Receivables ledger:individual customer accounts (invoices, credit notes, receipts).
• Payables ledger:individual supplier accounts (invoices, debit notes, payments).

The total of the subsidiary ledger balances should reconcile to the overall receivables/payables figure used in the financial statements. Regular reconciliation helps detect errors such as omissions, duplication, posting to the wrong side, and timing differences.

In questions, journal entries may be posted either to an individual customer/supplier account or to the receivables/payables control account, depending on what the scenario provides.

Irrecoverable debts (bad debts)

When a receivable is written off

A receivable is written off when there is clear evidence it will not be collected (for example, confirmed insolvency or a final confirmation that collection will not occur). A write-off is for a specific balance; it is not a general estimate.

Journal entry (write-off)

If a customer’s balance of £800 is confirmed irrecoverable:

• Dr Irrecoverable debts expense (profit or loss)£800
• Cr Trade receivables (customer account or receivables control)£800

Effect:

• Profit decreases (expense increases).
• Assets decrease (receivables reduced).
• Equity decreases through reduced retained earnings (via the reduction in profit).

Bad debt recoveries

Sometimes cash is received after a receivable has already been written off. Two common recording approaches are used in practice; both lead to the same overall effect on cash and profit.

Approach A: record the recovery as income (default teaching treatment)

• Dr Bank/Cash
• Cr Bad debt recovery income (other income)

Some questions present recoveries as a credit against impairment expense instead—follow the layout the question is using.

Approach B: reinstate then settle

Reinstate the receivable:

• Dr Trade receivables
• Cr Bad debt recovery income

Record the receipt:

• Dr Bank/Cash
• Cr Trade receivables

Do not record a recovery as sales, as that would distort revenue.

Allowance for credit losses on receivables

Purpose and presentation

Trade receivables are initially recorded at the invoice amount, but at each reporting date you should reflect that some customers may not pay in full. At this level, that is done by creating an impairment allowance (often taught as an “allowance for doubtful debts”).

The allowance is held in a separate ledger account with a credit balance and is presented as a deduction from trade receivables. In the statement of financial position, trade receivables are shown net of the impairment allowance, so users see the amount the entity realistically expects to collect.

IFRS note (exam-ready): in IFRS terms, this allowance represents an Expected Credit Loss (ECL) allowance on trade receivables. At this level (typically using the simplified approach for trade receivables), questions usually tell you how to estimate it, commonly using a percentage or an ageing approach.

How the allowance is calculated

Two common approaches are used:

1. Percentage of closing receivables
2. Apply a single percentage to closing receivables, after confirmed write-offs and after any permitted year-end adjustments explicitly stated in the question.
3. Ageing analysis
4. Split receivables by how long they have been outstanding and apply higher loss rates to older balances, then add up the results to obtain the required closing allowance.
5. Example of typical bands (illustrative):current 1%, 31–60 days 3%, 61–90 days 10%, over 90 days 25%.

Adjusting the allowance at the reporting date

Because the allowance already exists, you do not “post the allowance” each year—you post only the movement needed to reach the required closing balance.

The profit or loss entry is usually labelled:

• Impairment loss on trade receivables (ECL)(learning synonym: “doubtful debts expense”).

If the required allowance increases:

• Dr Impairment loss on trade receivables (ECL)
• Cr Impairment allowance (ECL) on trade receivables

If the required allowance decreases:

• Dr Impairment allowance (ECL) on trade receivables
• Cr Impairment loss on trade receivables (ECL)(a reversal)

Set-off (contra) between a customer and supplier balance

Sometimes the same counterparty is both a customer and a supplier. If the parties agree and intend to settle on a net basis (or to settle the two amounts simultaneously), the accounts may be cleared so that only the difference remains outstanding.

From a bookkeeping perspective, recording a contra moves value between receivables and payables and does not affect profit or cash. It prevents double counting open balances with the same party.

Important presentation point

There is a difference between ledger netting (how you operate the accounts day-to-day) and presentation in the statement of financial position:

• Ledger contra:you may record a contra in the ledgers when net settlement is agreed and will occur operationally.
• Statement of financial position presentation:show receivables and payables net only when you have a strong legal basis to offset and you actually expect to settle on a net (or simultaneous) basis. If not, keep gross presentation even if the ledger is cleared operationally.

Journal entry (contra)

If a set-off of £900 is agreed:

• Dr Trade payables (supplier account)£900
• Cr Trade receivables (customer account)£900

Impact on the accounting equation

The accounting equation is:

Assets = Liabilities + Equity

Irrecoverable debt write-off

• Assets decrease (trade receivables down)
• Equity decreases (profit down due to expense)
• Liabilities unchanged

Impairment allowance adjustment

• Assets decrease or increase (net receivables change via the allowance)
• Equity decreases or increases (profit changes via impairment loss/reversal)
• Liabilities unchanged

Contra

• Assets decrease (trade receivables down)
• Liabilities decrease (trade payables down)
• Equity unchanged

Worked example

Narrative scenario

A business has the following information for the year ended 31 December:

• Closing trade receivables before any year-end adjustments are £50,000.
• A customer balance of£800is confirmed irrecoverable.
• Existing impairment allowance on receivables (credit balance):£1,200.
• Required closing allowance:3% of receivables after the write-off and after the contra.
• The business has receivables from Orion Ltd of£1,500and payables to Orion Ltd of£900. A contra of£900is agreed.

Required

1. Write off the irrecoverable debt.
2. Record the contra arrangement.
3. Calculate the required closing impairment allowance (ECL).
4. Record the adjustment to the allowance.
5. Calculate net receivables for reporting.

Solution

1) Write off the irrecoverable debt

Journal

• Dr Irrecoverable debts expense £800
• Cr Trade receivables £800

Receivables after write-off
£50,000 − £800 = £49,200

2) Record the contra arrangement

Agreed contra: £900

Journal

• Dr Trade payables (Orion Ltd) £900
• Cr Trade receivables (Orion Ltd) £900

Receivables after contra
£49,200 − £900 = £48,300

3) Calculate the required closing impairment allowance (ECL)

Required allowance = 3% × £48,300
= £1,449

4) Adjust the impairment allowance

Existing allowance (credit) = £1,200
Required allowance (credit) = £1,449
Increase required = £1,449 − £1,200 = £249

Journal

• Dr Impairment loss on trade receivables (ECL) £249
• Cr Impairment allowance (ECL) on trade receivables £249

5) Net receivables for reporting

Net receivables = £48,300 − £1,449
= £46,851

Interpretation of the results

• The write-off removes an amount that is no longer expected to be collected, reducing receivables and reducing profit.
• The contra reduces receivables and payables; it cleans up balances but does not affect profit or cash.
• The impairment allowance ensures receivables are not overstated at the reporting date; only the movement from the existing allowance is recognised in profit or loss.

Exam focus

• Read the requirement carefully: journals may be requested for theindividual customer/supplier accountor for thecontrol account total. Post to whichever the question is using.
• Net receivables reported in the statement of financial position aregross receivables less the impairment allowance.
• Allowance adjustments go throughprofit or lossas an impairment loss (or reversal).
• A contra affects receivables and payables only; net presentation depends on whether net (or simultaneous) settlement is genuinely expected and supported.

Common pitfalls and misunderstandings

• Treating an estimate as a write-off:a write-off is for a specific balance that is no longer regarded as recoverable.
• Using the wrong base for the allowance:calculate the allowance after confirmed write-offs and after any permitted set-offs/adjustments explicitly stated in the question.
• Posting the allowance movement the wrong way round:an increase isDr impairment loss / Cr allowance; a decrease reverses it.
• Treating contras as cash:a contra is not a receipt or payment and should not appear in cash records.
• Recording recoveries as revenue:recoveries are not sales; show them as recovery income (other income) unless the question presents it as a credit against impairment expense.
• Mixing up gross and net receivables:financial statements show receivables net of the allowance, but ledgers still track gross customer balances.

Summary

Receivables and payables arise from credit transactions and must be recorded accurately to avoid misstated profit and working capital. A confirmed irrecoverable debt is written off by debiting an expense and crediting receivables. An impairment allowance (ECL) reduces receivables to an estimated recoverable amount, with only the movement recognised in profit or loss as an impairment loss (or reversal). Contras clear balances with the same counterparty without affecting profit or cash, but net presentation in the statement of financial position should only be used when net (or simultaneous) settlement is genuinely expected and supported by an appropriate legal basis.

FAQ

What is the difference between irrecoverable and doubtful debts?

Irrecoverable debts are specific balances confirmed as not collectible and written off. Doubtful debts refer to balances that are still outstanding but may not be collected; an impairment allowance (ECL) estimates the expected non-collection.

How is the impairment allowance shown in the financial statements?

It is presented as a deduction from trade receivables in the statement of financial position. The corresponding movement is recognised in profit or loss as an impairment loss (or reversal).

Does a contra affect profit?

No. A contra reclassifies balances between receivables and payables and does not create income or expense.

Glossary

Trade receivable
Amount owed by customers arising from credit sales, presented as a current asset.

Trade payable
Amount owed to suppliers arising from credit purchases, presented as a current liability.

Irrecoverable debt (bad debt)
A specific receivable that is no longer expected to be collected and is removed from the ledger, with an expense recognised in profit or loss.

Impairment allowance (ECL) on trade receivables
A credit balance that reduces gross receivables to an estimated recoverable amount, presented as a deduction from trade receivables.

Impairment loss on trade receivables (ECL)
The profit or loss charge (or reversal) needed to adjust the impairment allowance to the required closing balance (learning synonym: doubtful debts expense).

Contra (set-off)
An agreed clearing of amounts receivable from and payable to the same counterparty, reducing both balances without affecting profit or cash.

Net receivables
Gross receivables less the impairment allowance, representing the estimated recoverable amount reported in the statement of financial position.

Bad debt recovery
Cash received after a debt has been written off, recorded as recovery income (other income) or, where required by the question’s format, as a reduction of impairment expense.

Receivables ledger
Subsidiary ledger containing individual customer accounts supporting the total receivables balance.

Payables ledger
Subsidiary ledger containing individual supplier accounts supporting the total payables balance.

Aged receivables analysis
Grouping receivables by how long they have been outstanding to support an allowance estimate by applying loss rates by age band.

Statement reconciliation
Matching ledger balances to third-party statements (customers or suppliers) to identify timing differences, omissions, and posting errors.