What is bad debts?
What is bad debts?
The term Bad Debt usually refers to Accounts Receivable (or Trade Accounts Receivable ) that will not be collected. ( Bad debts are also used for notes receivable that will not be collected .) In accountancy we refer to such receivables as Irrecoverable Debts or Bad Debts . Bad debts could arise for a number of reasons such as customer going bankrupt, trade dispute or fraud. There are various technical definitions of what constitutes a Bad debt , depending on accounting conventions, regulatory treatment and the institution provisioning. Accounting sources advise that the full amount of a bad debt be written off to the profit and loss account or a provision for bad debts as soon as it is foreseen.
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| What is bad debts? |
The bad debts associated with accounts receivable is reported on the income statement as Bad Debts Expense or Noncollectable Accounts Expense.
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| More than Six Month overdue ! |
Recording Bad Debts
There are four methods for recording the bad debts associated with accounts receivable:
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Recording Bad Debts |
Direct write-off method , which removes the n on collectible amount directly from Accounts Receivable and records the amount as Bad Debts Expense. Direct write-off method is a receivable that is not considered collectible is charged directly to the income statement . This method is used in the United States for income tax purposes. However, while the direct write-off method records the precise figure for accounts that have been determined to be noncollectable , it fails to adhere to the matching principle used in accrual accounting and generally accepted accounting principles (GAAP).
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| Direct Write-off Method |
Allowance method , which estimates the probable amount that will not be collected, and immediately credits Allowance for Doubtful Accounts and debits Bad Debts Expense. Allowance method (GAAP) - Because no significant period of time has passed since the sale, a company does not know which exact accounts will be paid and which will default. So, an amount is established based on an anticipated and estimated figure. Companies often use their historical experience to estimate the percentage of sales they expect to become bad debt.
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| Allowance Method |
Accounts Receivable Aging Method, The aging method groups all outstanding accounts receivable by age and specific percentages are applied to each group. The aggregate of all groups' results is the estimated uncollected amount.
Accounts Receivable Aging Method
Percentage of Sales Method , The sales method applies a flat percentage to the total amount of sales for the period.
When recording estimated bad debts, a debit entry is made to bad debt expense and an offsetting credit entry is made to a contra asset account , commonly referred to as the allowance for doubtful accounts . The allowance for doubtful accounts nets against the total accounts receivable presented on the balance sheet to reflect only the amount estimated to be collectible. This allowance accumulates across accounting periods and may be adjusted based on the balance in the account.
Accounting entry required to write off a bad debt is as follows:
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| Accounting Treatment for Bad Dent Written off |
The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for doubtful accounts. At the end of each accounting cycle, adjusting entries are made to charge uncollected receivable as an expense. The actual amount of noncollectable receivable is written off as an expense from Allowance for doubtful accounts.
Bad debt expense is an unfortunate cost of doing business with customers on credit, as there is always a default risk inherent to extending credit.
To comply with the matching principle, bad debt expense must be estimated using the allowance method in the same period in which the sale occurs.
There are two main ways to estimate an allowance for Bad Debts : the percentage sales method and the accounts receivable aging method.
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| 5 criteria for Write-offs |
Five Criteria for Write-Offs "We write off debts that we determine are uncollectible. However, before resorting to this action all appropriate steps to collect the debt must be taken, which include exhausting both in-house and outside efforts." Normally, a write-off will be approved only if one of the following conditions exists:
ü A collection as the agency has been unable to collect the debt.
ü A judgment has been entered against the debtor and has failed to result in payment.
ü The cost of collecting the debt exceeds the recoverable amount.
ü The debtor has skipped and we're unable to locate the debtor.
ü from, The debtor filed for bankruptcy protection. "Once one of the above has occurred, the debt is written off to the bad-debt reserve account."
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| Bad Debt |
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