Businesses and individuals avail the facility of a loan in order to meet financial obligations. Similarly, companies sell products to customers on credit with a certain expectation of repayment.
It can happen that businesses do not receive all of the amount that it has offered in credit to customers, and such amount becomes uncollectible, also called bad debt.
Bad Debt Meaning
Bad debt is a type of account receivable for an organisation that has become uncollectible from the customer due to the customer’s inability to pay the amount of money taken on credit from the organisation.
The reasons that debtors are unable to repay can vary from the individual or organisation going bankrupt or having severe financial problems, or it can be due to unwillingness of the debtor to pay the debt.
Bad debts are recorded in the financial statements as a provision for credit losses.
Bad Debt Example
Bad debt example can be discussed as follows:
Let’s say Company ABC manufactures laptops and sells them to retailers. A retailer receives 30 days to pay Company ABC after receiving the laptops. Company ABC records the amount due as “accounts receivable” on the balance sheet and records the revenue.
However, as the 30 day due date passes, Company ABC realises the retailer is not going to make the payment. After repeated attempts, the company ABC is unable to collect the payment and hence, it will be considered as a bad debt.
Methods to calculate bad debt expense
There are two methods to calculate bad debt expense:
- Direct Write Off Method
- Allowance Method
Direct Write Off Method: In this method, the bad debt is directly written off to the receivables account. The bad debts account is debited and the accounts receivable account is credited.
There is one downside for this method, although it records the exact amount of debt that has become uncollectible, it does not adhere to the matching principle used in accrual accounting. As per the principle, an expense must be recorded at the time of the transaction, rather than at the time when payment is done.
Therefore, it is not very accurate in a theoretical way to determine bad debts.
Allowance Method: This method is preferable when there is a large amount of money involved. In this method, the organisation anticipates that bad debts are going to occur and prepares accordingly.
For this, an allowance for doubtful accounts is created, which is a type of contra asset account and reduces the loan receivable account when both accounts are listed in the balance sheet.
When a sale is made an estimated amount is recorded as a bad debt and is debited to the bad debt expense account and credited to allowance for doubtful accounts. When organisations want to write off the bad debt, the allowance for doubtful accounts is debited and accounts receivable account is credited.
Bad debt Accounting treatment
Bad debt accounting treatment is as follows:
Bad Debt Expense Dr
Receivable Account Cr
This was all about the Bad debts, which is an important part of accounting for organisations. It creates an impact on the revenue of the organisation. For more such interesting concepts of Commerce, stay tuned to BYJU’S.
Important Topics in Accountancy:
FAQs
Bad debt expense is used to reflect receivables that a company will be unable to collect. Bad debt can be reported on financial statements using the direct write-off method or the allowance method. The amount of bad debt expense can be estimated using the accounts receivable aging method or the percentage sales method.
What are the methods of bad debt accounting? ›
There are two different methods used to recognize bad debt expense. Using the direct write-off method, uncollectible accounts are written off directly to expense as they become uncollectible. On the other hand, the allowance method accrues an estimate that gets continually revised.
What is bad debts in accounting with an example? ›
For example, if a company sells its products on credit to a customer who fails to pay according to the terms agreed upon, the sale will be considered a bad debt after all efforts to recover the amount owed have been exhausted.
What is the treatment of bad debts? ›
Bad debt is accounted for by crediting a contra asset account and debiting a bad expense account, which reduces the accounts receivable.
How is bad debt treated in accounting equation? ›
Bad debts means that the debtor will not pay and the owner will lose the money. In accounting equation, the bad debt is reduced from debtors column and from capital column.
What is the direct method of accounting for bad debt? ›
1. Direct write-off method. The direct write-off method involves writing off a bad debt expense directly against the corresponding receivable account. Therefore, under the direct write-off method, a specific dollar amount from a customer account will be written off as a bad debt expense.
How is bad debt treated in balance sheet? ›
A.
First, bad debts will be shown in the Dr. side of the Profit & Loss A/c, being a loss for the business. Second, the amount of debtors appearing in the Balance Sheet would be reduced by the amount of bad debts.
What is the accounting entry for bad debt? ›
To record the bad debt entry in your books, debit your Bad Debts Expense account and credit your Accounts Receivable account. To record the bad debt recovery transaction, debit your Accounts Receivable account and credit your Bad Debts Expense account. Next, record the bad debt recovery transaction as income.
How are bad debts recorded? ›
Bad debts are recorded as a loss on the company's income statement. This means that the amount of the bad debt is subtracted from the company's total revenue. The bad debt is also removed from the accounts receivable balance on the balance sheet. Bad debts can be either short-term or long-term.
How is bad debt expense accounted for? ›
Bad debt expense or BDE is an accounting entry that lists the dollar amount of receivables your company does not expect to collect. It reduces the receivables on your balance sheet. Accountants record bad debt as an expense under Sales, General, and Administrative expenses (SG&A) on the income statement.
A bad debt might be recovered through a payment from a bankruptcy trustee or because the debtor has decided to settle the debt at a lower amount. A bad debt may also be recovered if an asset used as collateral is sold. For example, a lender may repossess a car and sell it to pay the outstanding balance on an auto loan.
What are examples of bad use of debt? ›
Good debt—mortgages, student loans, and business loans, steer you toward your goals. Bad debt—credit cards, predatory loans, and any loan used for a depreciating asset—steers you away from your goals.
What is the accounting treatment of bad debts recovered? ›
Bad debt recovered is typically recorded as a debit to the Allowance for Doubtful Accounts and a credit to Accounts Receivable. This means that the recovered debt is applied to the allowance account, reducing the amount of bad debt the company has provisioned for.
What is the accounting method for bad debts? ›
There are two ways to record a bad debt, which are the direct write-off method and the allowance method. The direct write-off method is more commonly used by smaller businesses and those using the cash basis of accounting. An organization using the accrual basis of accounting will probably use the allowance method.
What is an example of a bad debt in accounting? ›
Bad Debt Example
A retailer receives 30 days to pay Company ABC after receiving the laptops. Company ABC records the amount due as “accounts receivable” on the balance sheet and records the revenue. However, as the 30 day due date passes, Company ABC realises the retailer is not going to make the payment.
How do you adjust bad debts in accounting? ›
We show Bad debts on the debit side of Profit and loss account. Also, in the Balance Sheet, we deduct the amount of bad debts from the debtors. However, when the bad debts appear in the trial balance then in such a case we will debit it as an expense in the Profit & loss account only.
What are the methods of calculating bad debt expense? ›
What is the bad debt expense formula? To calculate bad debt expenses, divide your historical average for total bad credit by your historical average for total credit sales. This formula gives you the percentage of bad debt, which represents the estimated portion of sales deemed uncollectible.
What are the two methods for recording bad debt expense? ›
The two methods of recording bad debt are 1) direct write-off method and 2) allowance method.
What is the bad debt method required by GAAP? ›
The primary ways of estimating the allowance for bad debt are the sales method and the accounts receivable method. According to generally accepted accounting principles (GAAP), the main requirement for an allowance for bad debt is that it accurately reflects the firm's collections history.
What are the two methods of accounting for bad debts the direct write-off method and the allowance method? ›
The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes. The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account.
