Capital is the lifeblood of any business. Capital is a combination of equity and debt. So, any company needs debt and equity to balance its capital. When you heard the word ‘bad debt,’ you might wonder if there is any good debt too? Because all of us have a general perception that debt is a bad thing.
For any business, debt has many benefits that include a low-cost capital fund and tax deductions.
Debt, receivables, and dues are a normal affair of the business. You might allow your debtors to clear the payments for goods or services that they purchase or acquired in 15 days, 30 days, or sometimes 60 days too.
Let’s say the allowed period has passed, but no payments have been cleared yet. The debtor is also not responding to your calls; it is the danger alarm. At this stage, the money owed becomes doubtful debt. However, once the owed money becomes uncollectible, it is called bad debt.
Recording bad debts or doubtful debts is necessary to depict a business’s true and fair financial position. The event of bad debts must be recorded in the accrual accounting system. The condition is not true for cash-based accounting.
Although bad debts exist in cash-based accounting too. But, no entry for credit sales was made in the first place. Therefore, a reversal entry for bad debts is also not passed.
This article will explain what exactly bad debts are and how to do accounting for bad debts.
What Are Bad Debts?
We can define bad debts as,
‘Bad debt is an expense for any business entity. When the part of the company’s account receivables becomes uncollectible, bad debt expense must be recognized. in the company’s financial statements during the period it is incurred’
In other words, bad debts are unfortunate costs of any business due to
There might be different reasons why a bad debt expense occurs. Here are few reasons for bad debts.
- When the debtor fails to pay the debt within the specified time, it becomes bad debt
- The entity or creditor is unable to collect the debt due to technical reasons
- When the debtor shows an unwillingness to pay the debt amount or is incapable of paying the debt. i.e., bankruptcy
- Any debt becomes bad debt if there is some dispute over price, quality, or delivery of products
Bad debts Vs. Doubtful Debts
Bad debts and doubtful debts are often confused terms. Both terms are closely related, but there is a difference between the two. Let’s explain what factor distinguishes bad debts from doubtful debts.
Bad debts are the account receivables that have been clearly identified as uncollectible in the present or future time. The account receivables are credited by the amount of bad debt. The debtors who have become bad debts are removed from the accounts by passing an entry for bad debt expenses.
For example, the debtors’ business is bankrupt due to Covid-19 and they could not effort to pay off its debt that is own to the company. The account receivable from this specific debtor is considered, based on the company’s policies and its assessment as bad debts and the company should recognize it as expenses during the period in its profit and losses statement.
Doubtful debts cannot be specified with a surety. They are account receivables having a probability of becoming uncollectible in the future. You cannot ascertain a specific invoice or specific debtor to be doubtful debt.
It is done based on probability by creating a provision or allowance for doubtful debts. Provision for doubtful debt is a reserve calculated by different methods. We will discuss those methods in the coming sections of the article.
Criteria To Write Off Bad debts
Any business entity cannot record anything as a bad debt based on personal assumptions or gut. The company will have to establish that the specific account receivable is confirmed that they could not collect. There are certain criteria set to guide the deduction or write off the receivable as bad debts.
Bad debt is only deductible if:
- It is genuine. Genuine means that the amount due has become uncollectible with complete recognition.
- The account receivables have become uncollectible within the current tax year. The uncollectible amount can be whole or part of the total account receivable.
- The U.S. Code 166 guides the deduction of bad debts. Under the provision, business debt can be deducted as bad debt in part or whole, depending on the amount that has become uncollectible. However, for the deduction of non-business debt, the whole amount of debt must become irrecoverable.
- The debtor’s business become bankrupt and the company’s concluded that, based on it’s assessment, they could not recover from debtor.
Example Of Bad Debt
We have explained the reasons and criteria for the deduction of bad debts. However, examples can explain the concept more elaboratively.
Company Alpha is in the business of manufacturing spare parts for cars in the local market. It sells the goods to a retailer on term credit for 90 days. As the transaction occurs, the Retailer account receivable is debited to the balance sheet, and sales are credited in the income statement.
80 days pass, and the company comes to know that retailer has filed for bankruptcy and his assets have been liquidated. At this point, the debt has become uncollectible and become an expense for the company Alpha.
After the realization, the company will record the amount due in the bad debt expense. The account receivable will be credited and closed.
Methods Of Recording Bad Debts
There are two methods for recording bad debts. One is the direct write-off method, and the other one is the allowance method. Each method has a different use and relevancy in books of accounts. We will discuss each technique and scenario when they are used.
Direct Write Off Method
The direct write-off method directly deducts the bad debts from account receivables. As the name implies, once bad debts have been realized, they are recorded as an expense against the revenues. Under this method, no allowance is created, and the amount directly affects the net income.
For instance, in the one-year company had made a lot of credit sales hence increasing the net income. However, many debtors might become bad debt in the following year, putting pressure on the income statement.
The direct write-off method is extensively used in the United States for Income tax purposes. The direct method has the precision and accuracy of the actual amount going to bad debts. However, the technique has a very big downside.
The matching principle of GAAP is violated in the direct write-off method. The matching principle implies that the expenses related to certain revenues must be recorded against the same revenues. In the scenario discussed above, the matching principle is exploited. The direct write-off method is suitable for immaterial amounts that do not largely affect the income.
The second method is the allowance method. It is a more realistic and practical approach for recording bad debts. The allowance method or provision method is based on the contingency planning principles of accounting. The bad debts for a specific financial year are anticipated before they occur.
The reserve account for doubtful debts is created and maintained every year. The exact amount of the bad debts is deducted from the reserve account. Every year an anticipated amount based on historical data is credited to the reserve account.
The allowance method is mostly used by business entities to cater the large material amounts. The contra-account of ‘Provisions for doubtful debt’ is created in this method.
How to Calculate Bad Debts Provisions
In the allowance method for bad debts, the anticipation of bad debts is made. This anticipation cannot be made by assumptions. It requires some set rules and standards. There are two most commonly used methods for the estimation of bad debt provisions or doubtful debts.
Percentage Of Sales Method
In the estimation of bad debt provision under both techniques, historic figures are very critical. Another factor that contributes to the percentage of sales method is credit policy.
In this technique, an estimate is made about how much credit sales might become defaulter in the coming months or days. The percentage is calculated by closely analyzing the past years. Once the percentage is derived, it is multiplied by the current credit sales. This estimation shows the anticipated amount that will go to provision for doubtful debts.
Percentage Of Receivables Method
The percentage of the receivable method also encompasses the historical value of bad debts in the past years. The aging schedule is made in this method for accurate estimation. The percentage is also calculated in this method by the historic values.
The amount calculated by the aging schedule tells the minimum amount of bad debt reserve that the business entity must maintain. Let’s understand this by the illustration.
In the aging schedule, $437 is the most important figure. It is the total estimate of expected bad debts. Therefore, this amount shows the minimum reserve to be kept. For instance, if the reserve account already has $137, only $300 additional is required. That means that only $300 is recognized as an expense during the year. Not $437.
The following entry will be passed for recording the provision.
|Bad debt Expense||300|
|Allowance For Doubtful debt||300|
When there is a debit balance of the ‘allowance for doubtful debt’ account, what will be the solution?
Let’s say the account has a debit balance of $163. The minimum provision required is $437. Now we will add $437 and $163. A total amount of $600 will be credited against the bad debt expense. The following entry will be passed:
|Bad Debt Expense||600|
|Provision For doubtful debt||600|
Accounting For Bad Debts
Let’s have a look at the accounting treatment for bad debts.
We will take the example of Company Alpha. Let’s suppose the company had recognized the bad debts of $450 for the year 2020.
For the direct write-off method, the following entries will be passed in the books of accounts.
|Bad Debt Expense||$450|
If the same event occurs for the allowance method, the accounting treatment will be different. Let’s say the company had $600 in the allowance for doubtful debts. The actual value is $450. What will be the entry under the allowance method?
|Bad debt Expense||$450|
|Allowance For Bad debts||$450|
An additional journal entry will be recorded to balance off the contra account of allowance and write-off receivables.
|Allowance For Doubtful Debt||$450|
In this article, we have tried to comprehend the accounting for doubtful and bad debts. Recording and recognition of bad debts and doubtful debts are very critical to the company’s financial position. It is a requirement under the IFRS rules of contingencies. The matching principle of GAAP also implies recording related expenses and revenues within the same financial period.
By recognition of bad debts, the company’s assets or net income is not overstated or understated. Therefore, the true financial position of the company helps investors to decide about their investment decisions and stakes in the entity.