What is bad debt?
When a company sells products to its customers, it can either collect the payment or allow the customer to pay at a later date. In the case of credit sales, the company must record the sale and the associated receivable balance.
When the customer repays the amount later, the company records the receipt against the accounts receivable balance.
Sometimes, however, the customer may not be willing to repay due to various reasons. For example, a customer may go bankrupt and cannot afford to pay the related balance. If the company identifies an unrecoverable or uncollectable balance, it must expense out the balance. This expense is called bad debt.
Bad debts are a common type of expense for companies that offer credit sales. Therefore, all companies must record bad debts when they deem necessary. With experience, a company may also estimate the value of its bad debts based on a percentage.
According to accounting standards, the company must also record a bad debt allowance based on estimated amounts.
Therefore, there are two methods of writing off bad debts, the direct and the allowance methods. Given below is a comparison between both of them.
Bad debt write-off method
The bad debt write-off method, also known as the direct method, consists of writing off bad debts associated with specific account balances.
When a company determines that a customer cannot pay their accounts receivable balance, it can write off the balance. In this method, the specific amount of bad debt is clear to the company.
Example
A company, ABC Co., has total receivables of $20,000. Among these, there is a customer, XYZ Co., that has liquidated. The balance owed by XYZ Co. to ABC Co. was $3,000. ABC Co. believes that the customer cannot repay the balance in the future. Therefore, ABC Co. must write off the $3,000 owed from XYZ Co.
To write off the balance, ABC Co. can use the following double entry.
| Dr | Bad debt expense | $3,000 |
| Cr | Accounts receivable (XYZ Co.) | $3,000 |
Since the value of the balance owed by XYZ Co. is known, ABC Co. can write off the balance as bad debt. The bad debt expense will be a part of the company’s Income Statement for the period. On the other hand, the reduction in accounts receivable will be a part of its Balance Sheet.
Bad debt allowance methods
The bad debt allowance method allows companies to estimate the bad debts expense for the next accounting period. Once they calculate the allowance, they can write it off as bad debts. The bad debt allowance method follows the matching principle in accounting.
With direct bad debt write-offs, companies may expense out the balance that relates to other accounting periods. In contrast, companies only expense out bad debts based on the current period with the bad debt allowance method.
The bad debts written off using this method should be probable and calculated accurately. The bad debts allowance method also follows the prudence concept of accounting.
Bad debts recognized through this account do not reduce the accounts receivable balance of a company directly. Instead, companies use a specific account for it, known as Allowance for doubtful debts.
At the end of the period, companies must calculate their accounts receivable balance by deducting the balance in the Allowance for doubtful debt account from the accounts receivable balance.
Lastly, companies can estimate the allowance based on two methods, the aging method and the percentage of sales method. Both of them require the company to make estimates based on past experiences. However, one method considers the timing of accounts receivable as a base while the other considers sales.
Example
A company, ABC Co., has total accounts receivable of $20,000. The company has had some experience with bad debts in the past.
Based on that, it determines that out of the accounts receivable balances, 10% will result in bad debts. Therefore, ABC Co. must calculate the allowance and record it at the time of reporting.
The bad debt allowance that ABC Co. must recognize is $2,000 ($20,000 x 10%). Therefore, the journal entries for the allowance will be as follows.
| Dr | Bad debt expense | $2,000 |
| Cr | Allowance for doubtful debts | $2,000 |
At the end of the period, ABC Co.’s expenses will increase by $2,000 due to the allowance for bad debts. On the other hand, its accounts receivable in its balance sheet will be as follows.
| Accounts receivable | $20,000 |
| Allowance for doubtful debts | $(2,000) |
| Net accounts receivable | $18,000 |
Conclusion
Companies that offer credit sales may also suffer from bad debts. Bad debts are balances that a company deems irrecoverable or uncollectable.
There are two methods of writing off bad debts. These are the direct write-off method and the allowance method. The method of calculation of bad debts for both of these is different.