Bad debt expense:
Bad debt expense or doubtful debt expense is an operating expense related to the accounts receivable of the company.
It normally happens when the credit customers could not pay off the receivable, then the company already tries their best to recover, yet it could not get any positive results.
Then the company writes off those unrecoverable accounts receivable from its book.
To give you example, let we start from the recording receivable first.
When a company sells its goods or renders its services on credit, the following entry is passed:
Account Receivable Dr
Account receivable and revenue will be recognized at the same time in the financial statements.
When these accounts receivable fail to pay the amount they owe, the loss incurred by the company is referred to as a bad debt expense. And the expenses are recorded in the current period immediately.
In simpler words, bad debt expense is the noncollectable invoices.
There are two methods of reporting the bad debt expense:
- Allowance method
- Direct write-off method
In the allowance method, an estimate is calculated every year that is debited to the bad debt expense account.
Hence, before occurrence of a bad debt a provision is created in order to show a true and fair view of the company.
Direct write-off method:
In this article, we will focus on the direct write-off method. Contrary to the treatment in the allowance method, we report the bad debt expense when it occurs in the direct write-off method.
The accounts receivable is written off in the year customer provides evidence for the invoice being uncollectible instead of reporting it as a provision in the year the sales to the particular customer was made.
Nina sold goods to Stephanie for $5,000 on credit in November 2018. This was booked as sales in Nina’s books and an account receivable balance of $5,000 was reported for the year ended 2018.
In 2019, Stephanie failed to pay back the amount and a bad debt of $5,000 was recognized.
Instead of creating a provision on 2018, Nina will write off the bad debt in 2019 by debiting the bad debt expense account and crediting the accounts receivable as shown below.
Bad debt expense DR $5,000
Accounts Receivable CR $5,000
This means that the bad debt expense for the year 2019 has been overstated and the profit has been understated whereas bad debt expense for the year 2018 has been understated and profit for the year has been overstated as per the matching principle of accounting.
Hence, the company won’t be showing the true and fair view of its financial statements if the direct write-off method was used since it violates the basic principles of accounting.
This method delays the recognition of bad debt expense and goes against the prudence concept of accounting.
Any probable outflow of money or loss should be booked as an expense immediately.
Since sales are made on a credit basis there are chances of fraud and default payments which would result as an expense for the company at some point in the future.
An estimate shall be calculated each year and booked as an expense in order to avoid the wrong treatment of bad debt expense.
The direct write-off method is often used for tax purposes only and can also be used if the bad debt expenses are immaterial. An immaterial amount is usually 5% of the net profit.
So for example, Ali (one of your customers) filed for bankruptcy in 2019. He owed you an amount of $400 against purchases he made in 2017 that he can’t pay anymore since his bank loans exceeded his net assets.
Can this bad debt expense be treated as per the direct write-off method if the net profit for the year ended is $9,000?
The answer is yes since the bad debt expense is immaterial. It is less than 5% of $9,000 i.e. $450.
It would still be better if the bad debt expenses are booked as per the allowance method but wouldn’t really affect the reliability of financial statements since the amount is immaterial.