Bad Debts Expense: Definition, Example and Accounting Treatment

Yarab A |Updated on: December 13, 2021

• What is Bad Debts Expenses
• Bad Debts Meaning
• Accounting Treatment for Bad Debts Expenses
• Example of Bad Debts Expenses
• Bad Debts Expenses in Financial Statement
• Recovery of Bad Debts

What is Bad Debts Expenses

Debt is the most common word, not just in business but across different situations. Debt is the amount which is recoverable from a person or entity. You just lend a few hundred to your friend, its amounts to debt. In business, it arises more often when goods or services are supplied in credit terms.

There is no rocket science why a business supplies on credit. We all know that. The person to whom the credit is lent is known as ‘Debtors’. As long as he is in a position to pay you or you believe that you can recover the amount from him, is known as ‘good debts.

But when the situation of your customers gets worse or your belief that he will pay you is in doubt, is when you got to deal with the debts differently. This is when the theory of ‘Bad debts’ gets introduced.

Let’s understand bad debts.

Bad Debts Meaning

Bad debts are the debts which are uncollectable or irrecoverable debt. In simple words, it amount of debt which is impossible to collect is called bad debts.

When you are sure that you can’t recover the amount, you lent your friend is when the ‘debt’ becomes bad debts. The definition remains the same in the business as well, but the treatment of bad debts is a little different.

If it is definitely known to you that amount recoverable from a customer cannot be realized at all, it should be treated as a business loss and should be adjusted against profit. In other words, the amount of bad debt expenses should be transferred to Profit & Loss A/c for the current year to confirm the principles of matching.

The following section details the accounting treatment of bad debts.

Accounting Treatment for Bad Debts Expenses

*The last entry in the above table is closing entry and it has no relevance if are using accounting software. This because the closing entry as expenses are automatically considered in Profit & Loss A/c as when bad debts are transferred from debtor’s accounts.

Example of Bad Debts

On 1.4.2016, Pioneer Ltd sold goods to RAX Ltd for 40,000 TAK; On 15.4.2016 Rax Ltd paid 30,000 TAK to Pioneer Ltd. On 8.8.2016 Rax Ltd became insolvent and outstanding was not realized. Pioneer Ltd treated it has bad debts.

The Pioneer Ltd will record the following entries to give effect to bad debts in its books of accounts:

Bad Debts Expenses in Financial Statement

• Profit and Loss Account

All expenses which are not directly related to the main business activity will be reflected in the Profit & Loss A/c. These are mainly the administrative, selling and distribution expenses. Examples are salesmen commission, salary to office, insurance, legal charges, audit fees, advertising, free samples. Similarly, bad debts will also be shown in profit & loss a/c.

Profit and Loss Account (Extract)

For the year ended 30^th June 2016

Dr.                                                                                                                                  Cr

• In Balance sheet

The bad debts or a provision for bad debt is reduced from debtors and the net figure is shown in the balance sheet.

Balance sheet (Extract)

As on 30^th June 2016

Recovery of Bad Debts

We know that bad debt is a loss and is adjusted with the current year’s Profit & Loss A/c. Now, if the amount of bad debt is received in any succeeding year, the same will be credited to Profit and Loss of that year as an income. In simple words, recovery of bad debt is an income and posted to Profit & Loss A/c as profit.