Meaning of bad debts
When a company makes sales, it doesn’t collect cash from all the customers. Some customers pay at the time of purchase itself and some pay on credit terms. When customers fail to pay on due date and company assume that the money can’t be collected, then it is treated as bad debts. Due to the frequency of bad debts occurring in business, the company prepares provision for bad and doubtful debts.
Bad debt is treated as an expense in Profit and Loss Account since it is treated as loss to the company and the value of debtors is equally deducted with the amount of such bad debts. There are two methods of recording bad debts viz.
- Bad debts write-off method
- Bad debts allowance method
The two methods used in bad debts estimation are:
- Percentage of sales
- Percentage of receivables
Percentage of sales method:
It is an income statement approach. Bad debt expense shows the direct relationship in percentage to the sales revenue made by the company. This method gives a better way of matching expenses with the revenue. It involves the determination of the percentage of uncollectible net credit sales. It is determined by the company’s credit policy and past bad debt estimation behavior of the company.
Once the company determines the percentage, they multiply by the total credit sales to estimate the bad debt expense. This method does not consider the balance in provision for doubtful debts because such balances are not used while calculating bad debt expense.
Either net sales or credit sales can be used for calculation of bad debts. However, if the credit sales fluctuate much from one accounting period to others, using credit sales would be more accurate than the net sales method.
Example: A company estimated net credit sales of Rs 1,00,000. Using the percentage of sales method, they estimated 0.5% of sales to be uncollectible. So, the bad debt incurred here is 0.5% of Rs 100000= Rs 500.
The accounting for the above calculation is:
| Date | Particulars | Debit ($) | Credit ($) |
| Bad debts A/C DR | 500 | ||
| To Provision for doubtful debts | 500 |
It becomes irrelevant in this method what balance was there in provision for doubtful debts because bad debt is solely calculated based on credit sales.
While writing off the bad debts, the company has to debit the provision for doubtful debts and credit the debtors or accounts receivables account.
Example: Continuing with the above example, during December 2020 they learnt that debtors of Rs 2000 made in August became uncollectible then following journal entry is passed
| Date | Particulars | Debit ($) | Credit ($) |
| Provision for doubtful debts A/C DR | 500 | ||
| To Debtors | 500 |
Provision for doubtful debts is a contra asset that decreases the account receivables. It is recorded in the balance sheet on the assets side as a reduction from debtors.
It looks like this:
| Debtors | ### |
| Less: Provision for doubtful debts | (##) |
| Net debtors | ### |
If the doubtful debt turns into bad debt, then it is recorded as an expense in the income statement.
Bad debt allowance method:
This method is employed to prevent the overstatement of the accounts receivable. It involves the use of contra account of Allowance for doubtful debts in the balance sheet and bad debts account in the profit and loss statement.
The bad debt allowance method requires recording through several entries:
- The adjusting entry is passed at the close of the accounting period. It records bad debts on the debit side and credits the allowance for bad debts.
The entry is passed as
| Date | Particulars | Debit ($) | Credit ($) |
| Bad debts A/C Dr | ##### | ||
| To Allowance for doubtful debts | #### |
- The bad debt to be written off requires the recording through the following entry
| Date | Particulars | Debit ($) | Credit ($) |
| Allowance for doubtful debts A/C Dr | ##### | ||
| To Accounts receivable | #### |
This entry impacts the balance sheet only as the bad debt has already been expensed in P/L.
Recovery of bad debts:
Sometimes those debts which have been expensed in P/L get recovered as the debtors come and clear the debt amount.
The entry to be recorded is:
| Date | Particulars | Debit ($) | Credit ($) |
| Accounts receivable A/C Dr | ##### | ||
| Allowance for doubtful debts A/C | #### | ||
| Cash A/C Dr | ##### | ||
| Bad debt recovered A/C | #### |
The advantages of the allowance method are given below:
- It is based on the matching principle such that the bad debts are recorded as expenses in the year they generate.
- It depicts the accurate value of accounts receivables because its value is not overstated in the balance sheet.
The disadvantages of the allowance method are as follows:
- It requires more accounting work than the bad debts write-off method.
- It always risks misstatement due to the inaccurate estimation of bad debts.
