Bad Debts

Bad debts are accounts receivable that a company does not expect to collect and has written off to income statement as an expense. Bad debts are also called irrecoverable debts.

Bad debts are recognized as expense because they are not expected to generated any economic benefits in future. Recognition of bad debt expense also results in a corresponding decrease in the accounts receivable balance on balance sheet because bad debts are no longer an asset.

Although bad debts are a grim reality of doing business on credit, this does not mean that one should stop selling on credit since a good credit policy outweighs this draw back by a great margin. Selling goods on credit increases sales volume because customers like to have the ability to purchase on credit.

There are two methods of accounting for bad debts: (a) the allowance for doubtful accounts method and (b) the direct write-off method

Allowance for Doubtful Accounts

In the allowance for doubtful accounts method, bad debts expense is estimated and recognized in the period in which the relevant revenue is recognized. This makes it a more appropriate method than direct write-off method because it is in accordance with the matching concept.

In each period, doubtful accounts are estimated and expensed out by debiting ‘bad debts expense account’ and crediting allowance for doubtful accounts account.’ Following journal entry is required:

Bad debts expenseABC
Allowance for doubtful debtsABC

There are two methods for estimating bad debts: percentage of receivables and percentage of sales.

Subsequently, when it is confirmed that an account receivable is no longer collectible, it is removed by debiting the ‘allowance for doubtful debts account’ and crediting ‘accounts receivable.’ Following is the journal entry to recognize this:

Allowance for doubtful debtsDEF
Accounts receivableDEF

Direct Write-off

In direct write-off method, there is no estimation of doubtful debts. Instead bad debts expense is recognized when the account ‘actually’ turns out to be uncollectible and not just ‘potentially’ doubtful.

Direct write-off is recognized through the following journal entry:

Bad debts expenseDEF
Accounts receivableDEF

Example

Sillex, Inc. started operations on 1 January 2013. During the year ended 31 December 2013, the company’s sales amounted to $20 million out of which $4 million remained outstanding at the year end. Average accounts receivable outstanding during the first year amounted to $3 million. Since the company did not have any comprehensive accounts receivable policy during the first year of operations, it expensed out $220,000 of uncollectible accounts directly. The company’s management decided to apply the percentage of receivables allowance method for recognizing bad debts expense from 31 December 2013 onwards. Actual bad debts during the second year were $270,000.

Prepare all relevant journal entries related to bad debts accounting for the company’s first two year of operations.

Solution

During financial year 2013, the company applied the direct write-off method which involved expensing out actual bad debts as follows:

Bad debts expense220,000
Accounts receivable220,000

At the end of first year, the company needs to recognize an allowance for doubtful accounts based on the percentage of accounts receivable. The percentage can be worked out by dividing the actual bad debts during the first year by the average accounts receivable balance during the period.

Percentage of bad debts = $220,000/$3,000,000 = 7.33%

Potential bad debts expense for second year = 7.33% × $4,000,000 = $293,333

The allowance for doubtful debts shall be recognized at the end of first year as follows:

Bad debts expense293,333
Allowance for doubtful accounts293,333

Allowance for doubtful accounts is a contra-account to accounts receivable. Net accounts receivable balance on balance sheet as at 31 December 2013 shall be $ 2,706,667 ($3,000,000 less $293,333).

Actual bad debts during financial year ended 31 December 2014 are written off against allowance for doubtful accounts as follows:

Allowance for doubtful accounts270,000
Accounts receivable270,000

At the end of financial year ended 31 December 2014, allowance for doubtful accounts balance is increased to reflect the additional doubtful accounts.

Written by Irfanullah Jan