What is Bad debt?
At the end of the accounting period, a financial statement is prepared by every company, then at that time while preparing the financial statement, the company determines among its total receivable amount how much portion of receivables is collected by the company during that accounting period.
The portion of receivable that the company didn't receive and believes that it is uncollectible in future is called ‘bad debt expense’.
Bad Debt is often considered as a business expense because the goods or services are sold by the company on credit and the customer does not pay the due amount.So, it is an additional loss of the company which is often considered as an expense.
Bad debt Recovered – Bad debt recovery means the company receives the payment after it has been declared uncollected by the company.
When is it Recovered?
If the amount of bad debt is recovered after considering it as a bad debt by the company, then in that case the receivable amount is considered as revenue for the business. If the amount that is recovered is not equal to the bad debt amount, then the remaining amount is considered as usual as bad debt.
Reasons Leading to Bad Debt
The following are the reasons of bad debt:
- If the debtor faces any financial problem, he will not be able to pay the debt on time.
- One of the reasons might be, the debtor is not willing to pay the debt.
- It is not necessary that the problem will only be with the debtor, sometimes it is the creditor who fails to collect the debt from the debtor on due time due to certain reasons.
- One of the reasons may be due to some disputes arising regarding the price, quality, and delivery, credit term etcetera.
Methods of Recording Bad Debt
There are two methods of recording bad debt:
Direct Write-off Method
In Direct write off method, bad debt expense is regarded as a direct loss from the part of uncollected receivables, due to which the net income decreases.
For example – Suppose in one accounting year, a company’s receivables increase by a large number, Then in the next year, many customers could not pay them, which led to the reduction in the net income of the company. Therefore, the direct write-off method is only suitable for small amounts.
Bad debt allowance method is used by a company in case of a large amount. There are three primary components of the allowance method:
Estimating the portion of receivable that is yet not collected.
- Journal entry is recorded by passing a entry: debiting the bad debt expense account and crediting the allowance for doubtful accounts.
- In case of write-off allowance, doubtful accounts should be debited and corresponding receivable accounts should be credited.
For the purpose of making financial statement, allowance method is considered as a better method than direct write-off method because of the following reasons:
- The balance sheet gives more proper and realistic information about the portion of the account receivable or not.
- In the income statement, the amount of bad debt expense is reported closer to the time of the related credit sales.
For income tax purposes, the direct write-off method is considered better than the allowance method.
How to Estimate Accounts Receivable
Generally, the amount of uncollected receivable is only an estimation because it is very difficult or can be said that it is impossible to determine the exact value of bad debt expense. There are two methods used for estimating the value of bad debt expense:
1. Percentage of sales – The Percentage of sales determines how much percentage of total net credit sales is not yet collected. It is mainly determined through past experiences. Once the company identifies the percentage, after that the company multiplies the percentage by net credit sales, in order to find the bad debt expense.
For example – Company ABC has total credit sales of $100,000 and by using percentage of sales, the company estimated that 2% of their credit sales would not be collected.
Bad Debt expense A/c Debit $2,000
allowance for doubtful A/c credit $2,000
Here, the bad debt expense is estimated at $2,000 ($100,000 × 0.02).
Percentage of Receivable
Under the percentage of receivable, companies used to prepare an aging schedule.
Again, percentage of receivable is determined by some past experiences. Aging schedule shows the required balance amount of the allowance of doubtful accounts. In case, if there beforehand exists some credit balance in the allowance of doubtful accounts, then there is a need to adjust that amount.
For example –Suppose the total bad debt is $500 and $200 credit is already available in the allowance account.
Solution – So, the existing amount $200 will be subtracted from the total bad debt amount and it will be recorded as follows –
Bad debt expense A/c $300
Allowance for doubtful debt A/c $300
In place of credit balance,if a debit balance is available in an allowance doubtful account, then, we will simply add the amount of the existing balance, which is $200 with the total amount of bad debt.
Bad debt A/c $700
To Allowance for doubtful account a/c $700
Importance of Bad Debt Expense
It is quite common that each and every company prepares financial statements at the end of the accounting year or quarterly.
A company must ensure that the financial statement reveals the true and fair value of the company’s affairs because the investor analyzes the financial statement of the company before investing his hard-earned money in that company and in return if the company does not show the true financial report of itself, then it means the company is being disloyal to the investors by giving false information to attract those investors towards itself.
Bad debt expense is one of the important items that must be recorded by the company while preparing a financial statement. In case, if the company decides not to show it in the final account, it means the company is overstating the asset which means net income is also overstated.
The bad expense also helps the company to determine which customer did not make payment more often than others. And, if the company wants to use the loyalty system, then the account of bad debt helps the company to determine the creditworthiness of the customers, and also the company can give some discounts to the customers who pay their debts in time.
Accounting Treatment of Bad Debt
Bad debt is a business expense for a business. Therefore, in a profit and loss account, it is written on the debit side. And on the balance sheet, the amount of bad debt is subtracted from the debtor’s amount and the final amount is written on the asset side of the balance sheet.
- One should not be too nice or too rude with his customer. Being understanding with the customer is the key way to get the due payment.
- An effective form of communication is to be used with the customers so that they pay the due amount on time.
Context and Applications
This topic is significant in the professional exams for both undergraduate and
graduate courses, especially for
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