Key Concepts
When a business sells on credit, there is a risk that some customers will not pay. To prepare for this, at the end of the financial year the business reviews its trade receivables and estimates how much may not be collectible. This estimated uncollectible amount is recorded as the Allowance for impairment of trade receivables.
The allowance is a contra-asset account — it normally carries a credit balance and is deducted from trade receivables on the Statement of Financial Position. This gives the net trade receivables — the amount the business realistically expects to collect.
What is a contra-asset?A contra-asset account reduces the value of a related asset. It has a credit balance (the opposite of the asset's normal debit balance), but it is still shown together with assets on the Statement of Financial Position — as a deduction.
This follows the prudence theory, which states that assets and profits should not be overstated, while liabilities and losses should not be understated. As a business reviews its trade receivables and estimates the amount that may be uncollectible, it provides for an allowance for impairment of trade receivables. Presenting this as a deduction against the book value of trade receivables ensures that trade receivables are not overstated.
The allowance account is set up the first time a business makes an allowance, then adjusted at the end of each financial period in later years — not during the year.
Journal entry for setting up the allowance for the first time (recorded at the end of each financial year):
| Transaction | Debit | Credit |
|---|---|---|
| Setting up the allowance for impairment of trade receivables | Impairment loss on trade receivables (+expense) | Allowance for impairment of trade receivables (+contra-asset) |
Prudence: never overstate. The allowance is a cushion set against trade receivables. It is a contra-asset (normally a credit balance), so on the Statement of Financial Position it is deducted from trade receivables to give the net amount expected to be collected.
Allowance = 4% × $62,500 = $2,500
Since there was no existing allowance, the business increases the allowance by the full required amount.
| Date | Particulars | Dr ($) | Cr ($) |
|---|---|---|---|
| 20X7 | |||
| 31 Dec | Impairment loss on trade receivables | 2,500 | |
| Allowance for impairment of trade receivables | 2,500 |
Statement of Financial Performance for the year ended 31 December 20X7 (extract)
| $ | |
|---|---|
| Less: Other expenses | |
| Impairment loss on trade receivables | 2,500 |
Statement of Financial Position as at 31 December 20X7 (extract)
| $ | $ | |
|---|---|---|
| Current assets | ||
| Trade receivables | 62,500 | |
| Less: Allowance for impairment of trade receivables | (2,500) | 60,000 |
Recording the allowance as a debit balance. The allowance is a contra-asset — it normally carries a credit balance. On the Statement of Financial Position it is deducted from trade receivables.
Applying the percentage to the wrong figure. The allowance is a percentage of the ending trade receivables balance, not of sales revenue or of cash collected.
Creating the allowance during the year. The allowance is set up and adjusted only at the end of the financial period.