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.
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