Bad debts are unavoidable for companies. Any company that offers credit sales will also have bad debts associated with them. It is because when a company offers credit sales, it accumulates accounts receivables. Accounts receivables are a group of balances that represents payments owed by third parties, usually customers, to the company.
Every company has its own credit policies. These policies depend on several factors, such as the size of the company, its nature, the industry it operates in, policies of its competitors, etc. Some companies may not offer credit terms at all and transact in cash only. However, for some others, not offering credit sales may not be an option.
Definition
Bad debt is a concept closely related to accounts receivable. Bad debts represent any balance that a company determines is unrecoverable. Bad debts can happen due to several reasons. For example, if a customer goes bankrupt or liquidates, it may not be able to repay its liabilities. Similarly, if the company does not evaluate the creditworthiness of a customer properly, it may result in bad debts.
Bad debt is an expense for a company. That is why it is a part of its Income Statement. However, bad debts also affect the Balance Sheet of the company. It is because bad debts cause a reduction in its accounts receivable balances, which is a Balance Sheet item. Overall, bad debts are bad for any company as they can result in significant losses.
Explanation
When it comes to bad debts, there are not many controls that companies can implement. It is because, for almost all companies around the world, bad debts are inevitable. Some companies may introduce credit policies and have a dedicated credit control department to tackle the issue. However, these still cannot prevent bad debts from happening.
Bad debts impact a company negatively in various ways. First of all, it results in sales without any proceeds. Furthermore, it can disrupt the cash management process of a company when expected cash inflows from accounts receivable fail to realize. Likewise, bad debts also increase the expenses of a company, which may result in losses for them.
For companies, generating revenues is a primary goal. It is because higher sales mean more profits and cash inflows. However, if they fail to recover the associated receipt with those sales, generating revenues is futile. Therefore, bad debts can be problematic for any company. The lower that companies can maintain their bad debts, the better it is for them.
Double-entry or Journal entry
There are two ways in which companies may record bad debts. First of all, bad debts may relate to specific accounts or customers. In that case, the expense is direct as it affects the company’s accounts receivable directly. When the company can identify the particular balance to which bad debts relate, it can write it off from the specific customer’s account. It is known as the direct method. In the case of a direct write-off, the double-entry is as follows.
| Dr | Bad debt expense | x |
| Cr | Customer account (Accounts receivable) | x |
In other circumstances, a company may also determine the percentage of its expected bad debts. In that case, the company estimates its bad debts for the period based on past experiences. Once it determines the amount, the company records it as a bad debt expense while also recognizing an allowance for doubtful debt. It is known as the bad debt allowance method. The double entry for it is as follows.
| Dr | Bad debt expense | x |
| Cr | Allowance for doubtful debt | x |
In the case of allowances, the company does not deduct the bad debt from a specific customer’s balance. Instead, it keeps it in a different allowance account, which causes a reduction in accounts receivable. However, it does not affect the accounts receivable balance of a company directly.
Sometimes, companies may also recover the balances they recorded as bad debts. In that case, the net double entry will be as follows.
| Dr | Allowance for doubtful debt | x |
| Cr | Cash | x |
Example
A company, ABC Co., has total accounts receivable balance of $100,000. Out of this balance, the company considers $10,000 from a specific customer, XYZ Co., to be uncollectable. Similarly, ABC Co. expects a further 10% of the remaining amount to be irrecoverable based on past experiences. Therefore, ABC Co. must record both these transactions as bad debts.
Firstly, ABC Co. must recognize the specific bad debt related to XYZ Co. The double entry will be as follows.
| Dr | Bad debt expense | $ 10,000 |
| Cr | XYZ Co. (Accounts receivable) | $ 10,000 |
After this double entry, the remaining balance in accounts receivable will be $90,000 ($100,000 – $10,000). From this amount, the company can calculate the allowance for bad debts, which will be $9,000 ($90,000 x 10%). The double entry for it will be as follows.
| Dr | Bad debt expense | $ 9,000 |
| Cr | Allowance for doubtful debt | $ 9,000 |
The accounts receivable balance on ABC Co.’s Balance Sheet will be as follows.
| Accounts receivable | $ 90,000 |
| Allowance for doubtful debts | $ (9,000) |
| Net accounts receivable | $ 81,000 |
Conclusion
Bad debts are an inevitable part of the business for companies that offer credit sales. These represent balances that a company considers uncollectable. Bad debts can negatively impact a company as they increase expenses while decreasing assets.