Accounts receivable is the amount owed to the entity by the customers that have bought goods from the entity on credit i.e. the sale has been made but the payment has not been received yet at the end of the accounting period. Month or year. Even though the payment is not collected, the entity still needs to recognize sale revenue and account receivable. The accounting entry to record accounts receivables is:
Accounts receivable Dr
Sales Cr
When such sales are made, many customers end up defaulting on their payments, and this results in a loss for the company. This loss or expense is then written off from the accounts receivable account.
There are two ways of doing so. The two methods for writing off bad debts are referred to as:
- Direct-write off method
- Allowance method
Direct write-off:
In the direct write-off method, when after a few years of trying to recover the amount the invoice is declared as bad or uncollectible, it is directly written off or expensed out in the income statement by debiting bad debt expense and crediting accounts receivable.
The following journal entry is passed:
Bad debt expense Dr
Account receivable Cr
Example:
For example, Nate made sales of $9,000 to Serena on credit in 2017. After so many attempts of trying to recover the money by Nate in 2019, Serena filed for bankruptcy and was unable to pay back Nate. Since Nate could not collect the receivable from Serena, this $9,000 should be written off during 2019.
How is Nate supposed to go about this bad debt expense?
Nate should pass the following journal entry in his books to write off Serena from his accounts receivable:
Bad debt expense Dr 9,000
Accounts receivable Cr 9,000
$9,000 shall be reported as an operating expense in his income statement for the year ended 2019 and accounts receivable on his balance sheet shall be reduced by this amount.
Allowance method:
At the end of every accounting period, an estimate of doubtful debts is measured. Doubtful debts are those invoices against which sales have been made on credit but they are not expected to be turned into cash for various reasons.
For example, one of your customers may have faced a huge loss or is maybe facing liquidity issues or may have huge loans to pay off.
Any such customers might not be able to pay back the debt due to their deteriorating financial position.
Such debts are future losses and shall be expensed out immediately as per the prudence concept also known as the conservatism principle.
Since it is unknown to the company what amount each customer would default, the accounts receivable cannot be simply written-off. This is why a contra account is created known as the provision for doubtful debts or allowance for doubtful debts.
It is a credit account in nature because it is related to accounts receivable (asset). The provision account reduces the value of accounts receivable on the balance sheet to its net realizable value.
This means that the company reports the original amount the customers owe as accounts receivable. Still, those accounts receivable that are not expected to be turned into cash are reported under the provision for doubtful debts.
Accounting of bad debt expense:
The bad debt expense is recorded by passing the journal entry:
Bad debt expense Dr xxx
Provision for bad debt Cr xxx
This provision, when actually turned into bad debt after several attempts of trying to recover the money is written-off from the accounts receivable account through the following journal entry:
Provision for bad debt Dr xxx
Accounts Receivable Cr xxx
Example:
ABC has a closing balance amounted to $20,000 in trade accounts receivable. At the start of the year, management decides to create a 2% provision for the bad debts.
At the end of the year, management decides to write off XYZ LTD’s debtor account balance as bad debt. The debit balance of the XYZ LTD account is $500.
Required: Pass the general Entries
Bad Debts A/C DR $400
Provision for Bad Debts CR $400
and,
Bad Debts CR $100
Provision for Bad Debts DR $400
XYZ Receivable Account CR $500
