Bad Debts Concept
Accounts receivable are not always collected in full due to various reasons. Sometimes customers simply evade payment and the cost of pursuing them is more than the recoverable amount, sometime they become bankrupt, sometimes the debt becomes time-barred etc. A debt which is determined to be uncollectible i.e. there is no chance that the debt would be collected, is called a bad debt. Bad debts are written off from accounts as soon as they are determined. This is because a business does not expect future economic benefits from a bad debt and it no longer remains 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.
Doubtful accounts are the accounts receivable which are likely to be uncollected or, in other words, these are potential bad debts.
Accounting for Bad Debts
There are two methods of accounting for bad debts:
Briefly stated, the direct write-off method directly writes off accounts receivable against income. This method is not according to GAAP because it often violates the matching principle of accounting. The allowance method estimates doubtful debts and transfers them to a reserve account before they are actually determined as uncollectible. Allowance method is according to GAAP.
Written by Irfanullah Jan