Any company that has a policy of selling goods on credit has to deal with the problem of bad debts. Bad debts are uncollectible invoices that are written-off from the accounts receivable after all attempts of recovery have been made.
This loss of revenue is referred to as a bad debt expense.
As per the international accounting standards (IAS), any expense incurred shall be reported on the income statement of the entity.
An income statement is a financial statements that must be prepared at the end of each accounting period as per the IAS and reports the net income or loss earned by the company.
Now the question arises, how to report the bad debt expense? Should we just report it as an expense when the invoices are declared uncollectible? Is it that easy?
Unfortunately, this method of writing off bad debt violates the generally accepted accounting principles and is not appropriate for reporting financial statements with a true and fair view.
There are two methods of reporting bad debt expense; the direct write-off method that is explained above and the allowance or provision method.
Direct Written Off Method
This method is used by organizations to write off the bad debts arises from the credit sales that are directly written off as an expense to the income statement.
Generally, this method is used when accounts are prepared for taxation purposes.
Allowance/ Provision Method:
The allowance method requires you to create a bad debt provision against doubtful debts. Doubtful debts are invoices that are included in accounts receivable but are not expected to be turned into cash.
As per the generally accepted accounting principles (GAAP), these expected uncollectible invoices shall be reported as an expense.
The prudence concept requires you to book an expense as soon as it is probable (more likely than not) and recognize revenue only when certain.
This implies that the accounts receivable and the net profit would be overstated if no doubtful debts are written-off or expensed out.
How to calculate the doubtful debts?
The doubtful debts are projected based on the invoices that haven’t been paid for in a long time or are calculated as a percentage of sales or accounts receivable.
This estimate can’t be directly written off from the accounts receivable account since no specific invoice can be proven bad in the present.
Hence a contra asset account is created since this amount is a credit balance on accounts receivable (asset) and can’t be classified as a liability.
This estimate is referred to as a provision because it is an expense that would occur in the future at an uncertain time. The journal entry to create provision is shown below:
Bad debt expense DR
Provision for bad debt CR
The provision for bad debt is estimated each year at the end of the accounting period. This way the matching principle of accounting is followed and no GAAP are violated.
The matching principle states that every entity must book its expenses that relate to the revenue it has generated.
The provision for bad debt expenses out any future uncollectible invoice related to the accounts receivable booked this year no matter when the bad debt occurs.
This way only the balance sheet items are affected and there is no effect of bad debt expense on future income statements. The following entry is passed to write-off accounts receivable that defaulted their payments:
Provision for bad debt Dr
Accounts receivable Cr
The doubtful debts have decreased since they have gone bad hence a debit to provision for bad debt is recorded. Simultaneously, the accounts receivable is written-off by a credit to its account.