Bad debts are accounts receivable that a company does not expect to collect and has written off to income statement as an expense. Bad debts are also called irrecoverable debts.
Bad debts are recognized as expense because they are not expected to generate any economic benefits in future. Recognition of bad debt expense also results in a corresponding decrease in the accounts receivable balance on balance sheet because bad debts are no longer an asset.
Although bad debts are a grim reality of doing business on credit, this does not mean that one should stop selling on credit since a good credit policy outweighs this draw back by a great margin. Selling goods on credit increases sales volume because customers like to have the ability to purchase on credit.
There are two methods of accounting for bad debts: (a) the allowance for doubtful accounts method and (b) the direct write-off method
Allowance for Doubtful Accounts
In the allowance for doubtful accounts method, bad debts expense is estimated and recognized in the period in which the relevant revenue is recognized. This makes it a more appropriate method than direct write-off method because it is in accordance with the matching concept.
In each period, doubtful accounts are estimated and expensed out by debiting ‘bad debts expense account’ and crediting allowance for doubtful accounts account.’ Following journal entry is required:
|Bad debts expense||ABC|
|Allowance for doubtful debts||ABC|
There are two methods for estimating bad debts: percentage of receivables and percentage of sales.
Subsequently, when it is confirmed that an account receivable is no longer collectible, it is removed by debiting the ‘allowance for doubtful debts account’ and crediting ‘accounts receivable.’ Following is the journal entry to recognize this:
|Allowance for doubtful debts||DEF|
In direct write-off method, there is no estimation of doubtful debts. Instead bad debts expense is recognized when the account ‘actually’ turns out to be uncollectible and not just ‘potentially’ doubtful.
Direct write-off is recognized through the following journal entry:
|Bad debts expense||DEF|
Sillex, Inc. started operations on 1 January 2013. During the year ended 31 December 2013, the company’s sales amounted to $20 million out of which $4 million remained outstanding at the year end. Average accounts receivable outstanding during the first year amounted to $3 million. Since the company did not have any comprehensive accounts receivable policy during the first year of operations, it expensed out $220,000 of uncollectible accounts directly. The company’s management decided to apply the percentage of receivables allowance method for recognizing bad debts expense from 31 December 2013 onwards. Actual bad debts during the second year were $270,000.
Prepare all relevant journal entries related to bad debts accounting for the company’s first two year of operations.
During financial year 2013, the company applied the direct write-off method which involved expensing out actual bad debts as follows:
|Bad debts expense||220,000|
At the end of first year, the company needs to recognize an allowance for doubtful accounts based on the percentage of accounts receivable. The percentage can be worked out by dividing the actual bad debts during the first year by the average accounts receivable balance during the period.
Percentage of bad debts = $220,000/$3,000,000 = 7.33%
Potential bad debts expense for second year = 7.33% × $4,000,000 = $293,333
The allowance for doubtful debts shall be recognized at the end of first year as follows:
|Bad debts expense||293,333|
|Allowance for doubtful accounts||293,333|
Allowance for doubtful accounts is a contra-account to accounts receivable. Net accounts receivable balance on balance sheet as at 31 December 2013 shall be $ 2,706,667 ($3,000,000 less $293,333).
Actual bad debts during financial year ended 31 December 2014 are written off against allowance for doubtful accounts as follows:
|Allowance for doubtful accounts||270,000|
At the end of financial year ended 31 December 2014, allowance for doubtful accounts balance is increased to reflect the additional doubtful accounts.
Written by Irfanullah Jan
Bad debt expense is the amount of an account receivable that is considered to not be collectible. The amount of this expense reflects the credit choices made by a business when extending credit to customers. The amount of bad debt charged to expense is derived by one of two methods, which are:
- Direct write off. When it becomes apparent that a specific customer invoice will not be paid, the amount of the invoice is charged directly to bad debt expense. This is a debit to the bad debt expense account and a credit to the accounts receivable account. Thus, the expense is directly linked to a specific invoice. This is not a reduction of sales, but rather an increase in expense.
- Allowance method. When sales transactions are recorded, a related amount of bad debt expense is also recorded, on the theory that the approximate amount of bad debt can be determined based on historical outcomes. This is recorded as a debit to the bad debt expense account and a credit to the allowance for doubtful accounts. The actual elimination of unpaid accounts receivable is later accomplished by drawing down the amount in the allowance account. This is not a reduction of sales.
The bad debt expense calculation under the allowance method can be determined in a number of ways, such as:
- Applying an overall bad debt percentage to all credit sales
- Applying an increasingly large percentage to later time buckets in which accounts receivable are reported in the accounts receivable aging report
- Based on a risk analysis of each customer
No matter which calculation method is used, it must be updated in each successive month to incorporate any changes in the underlying receivable information.
The direct write off method is not the most theoretically correct way to recognize bad debt expense, since the expense is recognized several months later than the revenue associated with the initial sale, thereby separating elements of the same transaction into different time periods. The more correct approach is the allowance method, since a portion of all sales is reserved against as soon as revenue is recognized. In the latter case, revenues and related expenses appear in the same time period, so one can see the full impact of all sales on profits within the same accounting period.
The bad debt expense appears in a line item in the income statement, within the operating expenses section in the lower half of the statement.
As an example of the allowance method, ABC International records $1,000,000 of credit sales in the most recent month. Historically, ABC usually experiences a bad debt percentage of 1%, so it records a bad debt expense of $10,000 with a debit to bad debt expense and a credit to the allowance for doubtful accounts. In the following months, an invoice for $2,000 is declared not collectible, so it is removed from the company's records with a debit of $2,000 to the allowance for doubtful accounts and a credit to accounts receivable.
Credit and Collection Guidebook