Accounting, Bad Debts, and Provision for Doubtful Debts

An account receivable is an accounting documentation given to a business owner for the goods or services their customers has previously bought on credit. This account is recorded as an asset under the accounting balance sheets. Account receivable is very important in business as it helps to account for debtors and the transaction they made with a business and to also create deadlines for their debt to be paid (Hartmann-Wendels and Stöter 2012). Accounting for the recievables of accounts makes it easy to understand the past durations of pay from people owing and allows the business to set a deadline that allows the debtors to make the payments. Accounting for accounts receivables also makes it possible for a business to understand the decisions that must be made in the management of debtors such as amount of credit to allocate to those who pay their debts and the costs that need to be allocated in running a credit facility (Mian and Smith 1992). It is important to account for bad debts because it enables a business to assess its actual financial position when revenues that are less likely to be received are deducted from its current assets. This provides the business with a realistic value of its current assets which also leads to the achievement of a more realistic value of total assets. A business is required to account for the provision for bad and doubtful debts because it provides the business with a better understanding of debts that are less likely to be paid. This can be useful when creating financial statements such as income statements that shows an approximate financial position of a business when doubtful debts have been put into consideration. Accounting for bad and doubtful debts is important in providing a guide on the credit policies that a business needs to develop such as the maximum debts allowable in future depending on past repayments of debts.

Most Commonly used Methods for Provision for Doubtful debts

A major technique used to account for the provision for doubtful debts is specific identification. This is achieved by examining the list of debtors and establishing those who are less likely to pay their debts depending on previous experiences of transactions with them. The credit rating is used as measure of determining the doubtful debts (Magpantay 2013). The pros of this method of accounting for doubtful debts are that the likelihood of not repaying debt by one debtor does not affect other debtors. It is also curate because it is based on experiential observation of the difficulty in collecting debts from specific debtors. It is a more suitable method of distinguishing debtors who are more likely to repay their debts from those who are less likely to do so, thus enabling a business owner to follow up on debts collection. The cons of this technique of provision for bad and doubtful debts is lack of accuracy in estimating the likelihood of debt repayment since some debtors may repay earlier than their previous repayment durations while others who are expected to pay earlier may pay later than their expected repayment times. It is validity may be affected by bias towards certain customers based on their relationships with a business owner.
Provision for doubtful debts is also performed by determining a certain percentage of credit sales as doubtful debts. In this situation, an organization may decide that a certain percentage is of bad debts may not be paid depending on past records. They will set that percentage as doubtful debts for the present credit sales. The pros of this method is that it uses a uniform method for calculating doubtful debts that is closer to an accurate value based on the percentage of bad debts in an organization’s records (Sigidov et al. 2016). It is also easier to implement when using technical analysis methods of bad debts estimation and less likely to be affected by personal bias in favor of particular debtors in relation to their likelihood of repaying debts. The con of this method of estimation of doubtful debts is that it does not account for specific debtors who have a high chance of repaying their debts or those who are least likely to repay their debts. It cannot be effective when there is the need to reduce the amount of bad debts such as following up debtors who are more likely to repay their debts.&

An example of a case of real experience of Accounts receivable Fraud

An example of a case of accounts receivable (A/R) fraud occurred at Thornton Precision Components, now renamed Symmetry Medical Sheffield Limited in 2005 and 2006 when it created fictitious accounts receivable sub-ledger in Excel. This ledger was downloaded ton the real sub-ledger and incorporated into the company’s Excel file. Fictitious amounts of accounts receivables were then inserted (Jones 2011). The records reflected only the accounts receivables by customer. Due to this fraud, the amounts of accounts receivable in 2005 was inflated by £4,122,000 (38%) while in the 2006 financial year, it was inflated by £6,031,000 or (48%). Due to this fraud, the organization’s books and records were declared as materially inaccurate in the period between 2005 and 2006. The revelation of the fraud resulted into suspension of J.Kelly and Margaret Hebb nee Whyte from accounting practice due to their involvement in facilitating the fraud. It was suggested that a major factor the contributed to this fraud is lack of internal controls at the TPC subsidiary such as ineffective operational level controls, monitoring controls, and lack of disclosure of critical information for effective evaluation of transactions and accounting entries to the company’s management and auditors. It was also established that there were ineffective control management practices for ledgers, journal records, and account reconciliations.

Constructive Suggestions for Effective Control of Accounts Receivables

In order to control the accounts receivables in an effective manner and prevent the chances of fraud, it is recommended that organizations should adhere to strict internal controls such as monitoring the operations at the corporate levels so that any collusion by the management team can be detected and reported. The corporate management teams should be provided with information about the source documents which are used to make journal entries for accounts receivable before they are authenticated into the financial statements (Mian and Smith 1992). There should be effective accounts reconciliation before creation of a balance sheet followed by seeking the approval of the entries using supporting documentations. There should be effective inventory management practices such as the use of enterprise resource planning (ERP) n controlling inventories and assessing the actual amounts of accounts receivables. The management of organizations need to conduct scrutinized assessments of the general ledgers and segregate duties in a manner that chances of committing fraud are prevented.

List of References

Hartmann-Wendels, T. and Stöter, A., 2012. Accounts receivable management and the factoring option: Evidence from a bank-based economy.
Jones, M. ed., 2011. Creative accounting, fraud and international accounting scandals. John Wiley & Sons.
Mian, S.L. and Smith, C.W., 1992. Accounts receivable management policy: theory and evidence. The Journal of Finance, 47(1), pp.169-200.
Magpantay, D.D., 2013. Equivalence of the 3 Methods of Estimating Bad Debts. International Journal of Science and Research (IJSR), India Online, ISSN, pp.2319-7064.
Sigidov, Y.I., Korovina, M.A., Trubilin, A.I., Govdya, V.V. and Vasilieva, N.K., 2016. Creation of Provision for Doubtful Debts. International Journal of Economics and Financial Issues, 6(4).