Accounting For Bad Debts: Definition, Example, Method and Calculation - Wikiaccounting (2022)

Capital is the lifeblood of any business. Capital is a combination of equity and debt. So, any company needs debt and equity to balance its capital. When you heard the word ‘bad debt,’ you might wonder if there is any good debt too? Because all of us have a general perception that debt is a bad thing.

For any business, debt has many benefits that include a low-cost capital fund and tax deductions.

Debt, receivables, and dues are a normal affair of the business. You might allow your debtors to clear the payments for goods or services that they purchase or acquired in 15 days, 30 days, or sometimes 60 days too.

Let’s say the allowed period has passed, but no payments have been cleared yet. The debtor is also not responding to your calls; it is the danger alarm. At this stage, the money owed becomes doubtful debt. However, once the owed money becomes uncollectible, it is called bad debt.

Recording bad debts or doubtful debts is necessary to depict a business’s true and fair financial position. The event of bad debts must be recorded in the accrual accounting system. The condition is not true for cash-based accounting.

Although bad debts exist in cash-based accounting too. But, no entry for credit sales was made in the first place. Therefore, a reversal entry for bad debts is also not passed.

This article will explain what exactly bad debts are and how to do accounting for bad debts.

What Are Bad Debts?

We can define bad debts as,

Bad debt is an expense for any business entity. When the part of the company’s account receivables becomes uncollectible, bad debt expense must be recognized. in the company’s financial statements during the period it is incurred’

In other words, bad debts are unfortunate costs of any business due to

There might be different reasons why a bad debt expense occurs. Here are few reasons for bad debts.

(Video) Current Assets & Current Liabilities - Explained in Hindi | #24 Master Investor

  • When the debtor fails to pay the debt within the specified time, it becomes bad debt
  • The entity or creditor is unable to collect the debt due to technical reasons
  • When the debtor shows an unwillingness to pay the debt amount or is incapable of paying the debt. i.e., bankruptcy
  • Any debt becomes bad debt if there is some dispute over price, quality, or delivery of products

Bad debts Vs. Doubtful Debts

Bad debts and doubtful debts are often confused terms. Both terms are closely related, but there is a difference between the two. Let’s explain what factor distinguishes bad debts from doubtful debts.

Bad debts are the account receivables that have been clearly identified as uncollectible in the present or future time. The account receivables are credited by the amount of bad debt. The debtors who have become bad debts are removed from the accounts by passing an entry for bad debt expenses.

Related article Gain or Loss on Extinguishment of Debt: Definition, Explanation, and Example

For example, the debtors’ business is bankrupt due to Covid-19 and they could not effort to pay off its debt that is own to the company. The account receivable from this specific debtor is considered, based on the company’s policies and its assessment as bad debts and the company should recognize it as expenses during the period in its profit and losses statement.

Doubtful debts cannot be specified with a surety. They are account receivables having a probability of becoming uncollectible in the future. You cannot ascertain a specific invoice or specific debtor to be doubtful debt.

It is done based on probability by creating a provision or allowance for doubtful debts. Provision for doubtful debt is a reserve calculated by different methods. We will discuss those methods in the coming sections of the article.

Criteria To Write Off Bad debts

Any business entity cannot record anything as a bad debt based on personal assumptions or gut. The company will have to establish that the specific account receivable is confirmed that they could not collect. There are certain criteria set to guide the deduction or write off the receivable as bad debts.

Bad debt is only deductible if:

  • It is genuine. Genuine means that the amount due has become uncollectible with complete recognition.
  • The account receivables have become uncollectible within the current tax year. The uncollectible amount can be whole or part of the total account receivable.
  • The U.S. Code 166 guides the deduction of bad debts. Under the provision, business debt can be deducted as bad debt in part or whole, depending on the amount that has become uncollectible. However, for the deduction of non-business debt, the whole amount of debt must become irrecoverable.
  • The debtor’s business become bankrupt and the company’s concluded that, based on it’s assessment, they could not recover from debtor.

Example Of Bad Debt

We have explained the reasons and criteria for the deduction of bad debts. However, examples can explain the concept more elaboratively.

Company Alpha is in the business of manufacturing spare parts for cars in the local market. It sells the goods to a retailer on term credit for 90 days. As the transaction occurs, the Retailer account receivable is debited to the balance sheet, and sales are credited in the income statement.

80 days pass, and the company comes to know that retailer has filed for bankruptcy and his assets have been liquidated. At this point, the debt has become uncollectible and become an expense for the company Alpha.

After the realization, the company will record the amount due in the bad debt expense. The account receivable will be credited and closed.

Related article 7 Best Calculator For CPA, CFA, And Accountants

Methods Of Recording Bad Debts

There are two methods for recording bad debts. One is the direct write-off method, and the other one is the allowance method. Each method has a different use and relevancy in books of accounts. We will discuss each technique and scenario when they are used.

Direct Write Off Method

The direct write-off method directly deducts the bad debts from account receivables. As the name implies, once bad debts have been realized, they are recorded as an expense against the revenues. Under this method, no allowance is created, and the amount directly affects the net income.

For instance, in the one-year company had made a lot of credit sales hence increasing the net income. However, many debtors might become bad debt in the following year, putting pressure on the income statement.

The direct write-off method is extensively used in the United States for Income tax purposes. The direct method has the precision and accuracy of the actual amount going to bad debts. However, the technique has a very big downside.

The matching principle of GAAP is violated in the direct write-off method. The matching principle implies that the expenses related to certain revenues must be recorded against the same revenues. In the scenario discussed above, the matching principle is exploited. The direct write-off method is suitable for immaterial amounts that do not largely affect the income.

Allowance Method

The second method is the allowance method. It is a more realistic and practical approach for recording bad debts. The allowance method or provision method is based on the contingency planning principles of accounting. The bad debts for a specific financial year are anticipated before they occur.

The reserve account for doubtful debts is created and maintained every year. The exact amount of the bad debts is deducted from the reserve account. Every year an anticipated amount based on historical data is credited to the reserve account.

The allowance method is mostly used by business entities to cater the large material amounts. The contra-account of ‘Provisions for doubtful debt’ is created in this method.

How to Calculate Bad Debts Provisions

In the allowance method for bad debts, the anticipation of bad debts is made. This anticipation cannot be made by assumptions. It requires some set rules and standards. There are two most commonly used methods for the estimation of bad debt provisions or doubtful debts.

Percentage Of Sales Method

In the estimation of bad debt provision under both techniques, historic figures are very critical. Another factor that contributes to the percentage of sales method is credit policy.

In this technique, an estimate is made about how much credit sales might become defaulter in the coming months or days. The percentage is calculated by closely analyzing the past years. Once the percentage is derived, it is multiplied by the current credit sales. This estimation shows the anticipated amount that will go to provision for doubtful debts.

Related article Economic Order Quantity - Formula, Example, and Explanation

Percentage Of Receivables Method

The percentage of the receivable method also encompasses the historical value of bad debts in the past years. The aging schedule is made in this method for accurate estimation. The percentage is also calculated in this method by the historic values.

The amount calculated by the aging schedule tells the minimum amount of bad debt reserve that the business entity must maintain. Let’s understand this by the illustration.

In the aging schedule, $437 is the most important figure. It is the total estimate of expected bad debts. Therefore, this amount shows the minimum reserve to be kept. For instance, if the reserve account already has $137, only $300 additional is required. That means that only $300 is recognized as an expense during the year. Not $437.

The following entry will be passed for recording the provision.

DateDescriptionL.FDebit($)Credit($)
Bad debt Expense300
Allowance For Doubtful debt300

When there is a debit balance of the ‘allowance for doubtful debt’ account, what will be the solution?

Let’s say the account has a debit balance of $163. The minimum provision required is $437. Now we will add $437 and $163. A total amount of $600 will be credited against the bad debt expense. The following entry will be passed:

DateDescriptionL.FDebit($)Credit($)
Bad Debt Expense600
Provision For doubtful debt600

Accounting For Bad Debts

Let’s have a look at the accounting treatment for bad debts.

We will take the example of Company Alpha. Let’s suppose the company had recognized the bad debts of $450 for the year 2020.

For the direct write-off method, the following entries will be passed in the books of accounts.

DateDescriptionL.FDebit($)Credit($)
Bad Debt Expense$450
Account Receivables$450

If the same event occurs for the allowance method, the accounting treatment will be different. Let’s say the company had $600 in the allowance for doubtful debts. The actual value is $450. What will be the entry under the allowance method?

DateDescriptionL.FDebit($)Credit($)
Bad debt Expense$450
Allowance For Bad debts$450

An additional journal entry will be recorded to balance off the contra account of allowance and write-off receivables.

DateDescriptionL.FDebit($)Credit($)
Allowance For Doubtful Debt$450
Account Receivables$450

Final Words

In this article, we have tried to comprehend the accounting for doubtful and bad debts. Recording and recognition of bad debts and doubtful debts are very critical to the company’s financial position. It is a requirement under the IFRS rules of contingencies. The matching principle of GAAP also implies recording related expenses and revenues within the same financial period.

By recognition of bad debts, the company’s assets or net income is not overstated or understated. Therefore, the true financial position of the company helps investors to decide about their investment decisions and stakes in the entity.

FAQs

What are the methods of accounting for bad debts? ›

¨ Two methods are used in accounting for uncollectible accounts: (1) the Direct Write-off Method and (2) the Allowance Method. § When a specific account is determined to be uncollectible, the loss is charged to Bad Debt Expense.

What are the two methods for calculating bad debt expense? ›

There are two main ways to estimate an allowance for bad debts: the percentage sales method and the accounts receivable aging method.

What is the meaning of bad debts in accounting? ›

Bad debt refers to loans or outstanding balances owed that are no longer deemed recoverable and must be written off. This expense is a cost of doing business with customers on credit, as there is always some default risk inherent with extending credit.

How do you calculate bad debt to sales? ›

The bad debt to sales ratio is the fraction of an organization's uncollectible accounts receivables in a year and its total sales. For example, company A is making $100,000 in revenue every year and is unable to collect $3,000. So, the bad debt to sales ratio is (3,000/100,000=0.03).

What is bad debt example? ›

Bad Debt Examples. Owing money on your credit card is one of the most common types of bad debt. Credit cards are issued by lenders and allow you to make purchases on credit. These cards can come with high interest rates (often with a rate of more than 20%) and can get out of hand quickly.

How do you calculate bad debt reserve? ›

To establish an adequate allowance for doubtful accounts, a company must calculate its bad debt percentage. To make that calculation, divide the amount of bad debt by the company's total accounts receivable for a period of time and then multiply that number by 100.

How do you calculate bad debt expense from balance sheet? ›

The balance-sheet approach to bad debts expresses uncollectible accounts as a percentage of accounts receivable. The difference between the current balance of allowance for doubtful accounts and the amount calculated using the balance sheet approach is the amount of bad debt expense for the period.

What are causes of bad debts? ›

Here are some of the main reasons it happens:
  • Easy credit. ...
  • A lack of financial understanding. ...
  • Signing surety for someone else's loan. ...
  • Info hidden in the small print. ...
  • Lack of financial management. ...
  • No distinction between wants and needs. ...
  • Worrying about your social status. ...
  • Dodgy investments.
Jun 14, 2015

What is provision for bad debts with example? ›

Provision for Bad Debts Defined

The provision for Bad Debts refers to the total amount of Doubtful Debts that need to be written off for the next accounting period. Doubtful Debt represents an expense that reduces the total accounts receivable of a company for a specific period.

How do you calculate bad debt Class 11? ›

Adjustment: Provide a 2% reserve for bad and doubtful debts on the debtors.
...
How is it calculated?
ParticularsAmount
Less Old Provision for Bad Debts (It shall be given in the trial balance on the credit side)(XXXXX)
New Provision/Reserve for Bad DebtsXXXXX
4 more rows

How do you calculate collection period? ›

The average collection period is calculated by dividing a company's yearly accounts receivable balance by its yearly total net sales; this number is then multiplied by 365 to generate a number in days.

What are examples of debts? ›

What Are Examples of Debt? Debt is anything owed by one party to another. Examples of debt include amounts owed on credit cards, car loans, and mortgages.

What are the three methods of estimating doubtful accounts? ›

In current accounting literature, we usually find three (3) methods of estimating bad debts. These refer to (a) aging the accounts receivable approach, (b) percent-of-receivables approach and (c) percentage-of-sales approach.

What are examples of good and bad debt? ›

“Good” debt is defined as money owed for things that can help build wealth or increase income over time, such as student loans, mortgages or a business loan. “Bad” debt refers to things like credit cards or other consumer debt that do little to improve your financial outcome.

What is reserve method? ›

reserve method (bad debts) accrual of bad-debt expense based on the projected worthlessness of receivables or prior experience with uncollectible receivables.

What is bad debt expense formula? ›

read more based on past experience and future estimation. Formula #1. Bad Debt Expense Formula = Sale for Accounting Period * Estimated % of Bad Debts. In the percentage of the outstanding debtor. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion.

How do you calculate bad expenses? ›

The bad debt expense for the current year is estimated by multiplying the bad debt percentage by the projected credit sales. Bad debt expense for the current year= Bad debt percentage X Projected credit sales.

What is balance sheet method? ›

What Is the Balance Sheet Formula? A balance sheet is calculated by balancing a company's assets with its liabilities and equity. The formula is: total assets = total liabilities + total equity. Total assets is calculated as the sum of all short-term, long-term, and other assets.

Is bad debt an asset? ›

An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable. The allowance, sometimes called a bad debt reserve, represents management's estimate of the amount of accounts receivable that will not be paid by customers.

How do you calculate provision for debtors? ›

The company decides to create a Provision for Bad Debts @ 5% and a Provision for Discount on Debtors @ 3% p.a. on sundry debtors.
  1. Provision for bad debts = 30,000 x5/100 = $1,500.
  2. Remaining good debtors = 30,000 – 1,500 = $28,500.
  3. Provision for discount on debtors = 28,500 x 3/100 = $855.
Sep 17, 2021

How do you calculate provision required? ›

uses the provision matrix. First and foremost, the company needs to calculate historical default rates.
...
Calculation of Provision for Doubtful Debts under Ind AS 109.
Ageing from invoice dateAmount outstanding (in lakhs)
31 – 60 days500
61 – 180 days380
181 – 365 days200
Above 365 days120
2 more rows
May 11, 2020

What is bad debt Class 11? ›

Bad Debts is the amount receivable by the business which becomes irrecoverable and is therefore, treated as a loss by the business and debited to the Profit and Loss Account.

How is current ratio calculated? ›

To calculate the current ratio, you'll want to review your balance sheet and use the following formula.
  1. Current Ratio = Current Assets / Current Liabilities. ...
  2. $200,000 / $100,000 = 2. ...
  3. $100,000 / $200,000 = 0.5.

How is payment cycle calculated? ›

How to calculate an average payment period
  1. Determine the average accounts payable. ...
  2. Divide total credit purchases by days in the period. ...
  3. Divide this result into the average accounts payable. ...
  4. Evaluate the average payment period ratio. ...
  5. Provides insight into overall cash flow activities.
Mar 8, 2021

What is credit period? ›

What is a Credit Period? The credit period is the number of days that a customer is allowed to wait before paying an invoice. The concept is important because it indicates the amount of working capital that a business is willing to invest in its accounts receivable in order to generate sales.

How do you calculate doubtful expense in accounting? ›

It estimates the allowance for doubtful accounts by multiplying the accounts receivable by the appropriate percentage for the aging period and then adds those two totals together. For example: 2,000 x 0.10 = 200. 10,000 x 0.05 = 500.

Which method for estimating bad debts is generally considered to be the most accurate? ›

Of these two estimation methods, the aging of accounts receivable method is generally considered to be more accurate than the percentage of credit sales method. The aging of accounts receivable method takes into consideration that, generally, the longer a receivable goes unpaid the less likely it is to be paid.

What are the three methods of estimating doubtful accounts? ›

In current accounting literature, we usually find three (3) methods of estimating bad debts. These refer to (a) aging the accounts receivable approach, (b) percent-of-receivables approach and (c) percentage-of-sales approach.

How do you calculate provision for bad debts adjustment? ›

Adjustment: Provide a 2% reserve for bad and doubtful debts on the debtors.
...
How is it calculated?
ParticularsAmount
Less Old Provision for Bad Debts (It shall be given in the trial balance on the credit side)(XXXXX)
New Provision/Reserve for Bad DebtsXXXXX
4 more rows

How are write offs calculated? ›

Actual Debt Write-Offs

For example, you have $20,000 in accounts receivable and a $300 allowance, for a net of $19,700. You determine that a customer who owes you $180 is never going to pay. To write off the debt, reduce both accounts receivable and the allowance by the amount of the bad debt – $180.

You might also like

Latest Posts

Article information

Author: Trent Wehner

Last Updated: 08/25/2022

Views: 5853

Rating: 4.6 / 5 (56 voted)

Reviews: 87% of readers found this page helpful

Author information

Name: Trent Wehner

Birthday: 1993-03-14

Address: 872 Kevin Squares, New Codyville, AK 01785-0416

Phone: +18698800304764

Job: Senior Farming Developer

Hobby: Paintball, Calligraphy, Hunting, Flying disc, Lapidary, Rafting, Inline skating

Introduction: My name is Trent Wehner, I am a talented, brainy, zealous, light, funny, gleaming, attractive person who loves writing and wants to share my knowledge and understanding with you.