Bad Debts Expense: Definition, Example and Accounting Treatment

Debt is a common term, not just in business but across various situations. It represents an amount recoverable from a person or entity. For instance, lending money to a friend creates a debt. In business, debts frequently arise when goods or services are supplied on credit terms.

Businesses extend credit for various strategic reasons. The person or entity to whom credit is lent is known as a ‘Debtor’. As long as you believe the debtor is capable of paying, or you can recover the amount, these are considered ‘good debts’.

However, when a customer's financial situation deteriorates, or your confidence in their ability to pay diminishes, you must treat these debts differently. This is where the concepts of ‘Bad Debts’ and ‘Provision for Bad Debts’ become crucial.

 What is Bad Debts Expenses

Bad debts are amounts owed to a business that are deemed uncollectable or irrecoverable.In simpler terms, it's the portion of accounts receivable that a company believes it will never collect from its customers. When you are certain that an amount lent cannot be recovered, that ‘debt’ becomes a bad debt. The definition remains consistent in business, but the accounting treatment can vary. 

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.

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

Bad Debts Meaning: The Direct Write-Off Method

The direct write-off method recognizes bad debts expense only when a specific account is identified as uncollectable. This method is straightforward but does not align with the matching principle, as the expense is recorded in a period different from when the revenue was earned. It is typically used by smaller businesses or when bad debt amounts are immaterial. 

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

Understanding Provision for Bad Debts (Allowance Method)

While the direct write-off method records bad debts when they are certain, generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) often require the use of the allowance method. This method involves estimating future bad debts and creating a 'provision' for them in advance.

What is Provision for Bad Debts?

Provision for bad debts, also known as the allowance for doubtful accounts, is an estimate of the amount of accounts receivable that a company expects will not be collected. It is a contra-asset account that reduces the total accounts receivable on the balance sheet to their net realizable value.

The primary purpose of creating a provision for bad debts is to adhere to the matching principle, which dictates that expenses should be recognized in the same period as the revenues they helped generate. By estimating and recording bad debt expense in the period of sale, businesses provide a more accurate picture of their profitability and financial health. It also aligns with the conservatism principle, which suggests anticipating losses but not gains.

Key Differences: Bad Debts Expense (Direct Write-Off) vs. Provision for Bad Debts (Allowance Method)

Understanding the distinction between these two approaches is crucial:

• Timing of Recognition:
  • Direct Write-Off: Bad debts are recognized as an expense only when they are definitively identified as uncollectable.
  • Allowance Method (Provision): Bad debts are estimated and recognized as an expense in the period of sale, before specific accounts are identified as uncollectable.
• Matching Principle:
  • Direct Write-Off: Does not adhere to the matching principle, as the expense may be recorded in a different period than the related revenue.
  • Allowance Method (Provision): Adheres to the matching principle by estimating and expensing bad debts in the same period as the credit sales.
• Financial Statement Impact:
  • Direct Write-Off: Directly reduces accounts receivable and records an expense when a specific account is written off.
  • Allowance Method (Provision): Creates an 'Allowance for Doubtful Accounts' (contra-asset) to reduce accounts receivable to net realizable value, and records 'Bad Debts Expense' when the provision is made.
• GAAP/IFRS Compliance:
  • Direct Write-Off: Generally not compliant with GAAP/IFRS, except when bad debt amounts are immaterial.
  • Allowance Method (Provision): Required by GAAP/IFRS for material amounts of bad debts.

Methods for Estimating Provision for Bad Debts

Businesses use various methods to estimate the amount of bad debts for their provision:

• Percentage of Sales Method: This method estimates bad debts as a percentage of total credit sales for a period. The percentage is usually based on historical data. For example, if 1% of credit sales historically become uncollectable, and credit sales are 1,000,000 TAK, the bad debt expense would be 10,000 TAK.
• Percentage of Receivables Method (Aging Schedule): This method estimates bad debts based on the age of outstanding accounts receivable. Older receivables are considered less likely to be collected. An 'aging schedule' classifies receivables by the length of time they have been outstanding (e.g., 1-30 days, 31-60 days, 61-90 days, over 90 days), and a different uncollectable percentage is applied to each age category. This method is generally considered more accurate as it focuses on the current balance of receivables.

Accounting Treatment for Provision for Bad Debts (Allowance Method)

The allowance method involves two main steps: creating the provision and writing off specific uncollectable accounts against it.

1. Creating the Provision (Estimating Bad Debts Expense)

At the end of an accounting period, an estimate of uncollectable accounts is made and recorded:

This entry increases Bad Debts Expense (an income statement account) and increases the Allowance for Doubtful Accounts (a contra-asset account on the balance sheet).

2. Writing Off Specific Bad Debts Against the Allowance

When a specific customer's account is deemed uncollectable, it is written off against the existing allowance. This entry does NOT affect Bad Debts Expense or net income at the time of write-off, as the expense was already recognized when the provision was created.

This entry decreases both the Allowance for Doubtful Accounts and Accounts Receivable, so the net realizable value of receivables remains unchanged.

Example of Provision for Bad Debts (Allowance Method)

Let's assume Pioneer Ltd uses the allowance method. At the end of 2016, based on an aging analysis, Pioneer Ltd estimates that 15,000 TAK of its outstanding receivables will be uncollectable. The Allowance for Doubtful Accounts currently has a credit balance of 2,000 TAK (before adjustment).

Step 1: Adjusting the Provision

Pioneer Ltd needs to increase the allowance to 15,000. Since it already has 2,000, it needs an additional 13,000 (15,000 - 2,000).

Step 2: Writing Off a Specific Bad Debt

Later, on 08.08.2017, Pioneer Ltd determines that 10,000 TAK owed by RAX Ltd (from the previous example) is definitely uncollectable.

Notice that the Bad Debts Expense is not debited here; it was debited when the provision was initially created or adjusted.

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.