4.4 Irrecoverable Debts and Provision for Doubtful Debts

Part 1: Irrecoverable Debts

What Are Irrecoverable Debts?

When a business sells goods on credit, it expects the customer to pay later. The customer owes money to the business — this amount is recorded as a trade receivable (money owed to the business by customers).

Sometimes, however, a customer simply cannot or will not pay. After all attempts to collect the money have failed, the business accepts that it will never receive payment. This unpaid amount is called an irrecoverable debt — a debt that cannot be collected.

Common reasons this happens:

• The customer has gone bankrupt or insolvent (meaning they have run out of money and cannot pay their debts)
• The business can no longer contact the customer
• The customer has closed down

Why Must Irrecoverable Debts Be Written Off?

When a business writes off a debt, it removes it from the accounting records. This is necessary for two reasons:

1. The Prudence Concept — This accounting principle says you should never overstate (show as bigger than reality) your assets or profits. If you keep a debt in your records that you will never collect, your assets look bigger than they really are. Writing off the debt gives a more realistic picture.

2. Accuracy — The financial statements should show the true value of what customers owe the business, not an inflated figure that includes uncollectable amounts.

Writing off an irrecoverable debt means:

• The trade receivable (the customer's account) is reduced — the business no longer shows that the customer owes money
• The irrecoverable debts account increases — this is treated as an expense, just like rent or wages. It reduces the profit for the year.