Companies offer credit sales, allowing customers to pay for products and services later. Companies record sales made on credit as accounts receivable. Later, they account for any repayments from customers as a reduction in that account. Sometimes, however, customers may also fail to repay their suppliers. In those cases, companies must write off bad debts.
What is a Bad Debt?
Bad debt is an expense that represents receivable amounts no longer collectible. As mentioned, companies record these amounts when customers fail to repay their owed amounts. Several reasons may exist for their failure to reimburse the company. For example, some customers may be going through bankruptcy or experiencing financial issues.
A bad debt represents an amount that a company deems as irrecoverable. This amount relates to the sales made to customers at an earlier date. For most companies offering credit terms, bad debts are inevitable. These amounts fall under the general administrative expenses reported in the income statement. Writing off bad debts helps represent a true and fair picture of accounts receivable balances.
What is the accounting for Bad Debts?
Companies report bad debts in the financial statements under two methods. The first of these includes the direct write-off method. Under this approach, companies write off bad debts directly against the related receivable account. Usually, companies estimate these bad debts through the corresponding transaction. This method of writing off bad debts is more accurate.
The other approach to reporting bad debts is the allowance method. It does not include a specific bad debt or account. Instead, it estimates the bad debt expense at the end of each accounting period. On top of that, it does not reduce the accounts receivable balance directly.
What are the journal entries for Bad Debts?
The journal entries for bad debts depend on the approach that companies use. As mentioned, these include the direct write-off and allowance methods.
Direct write-off method
Under the direct write-off method, companies report bad debts for specific receivable accounts. This approach involves recording an expense for the irrecoverable amount. On the other hand, it also reduces the receivable balance for the customer account. The journal entries for writing off bad debts under this approach are below.
| Dr | Bad debts |
| Cr | Accounts receivable |
Allowance method
Under the allowance method, companies estimate doubtful debts based on past experiences. Usually, this approach involves creating an expense of those amounts. On the other hand, it also requires companies to record a provision for those amounts. The journal entries for writing off doubtful debts under the allowance method are below.
| Dr | Doubtful debts |
| Cr | Allowance for doubtful debts |
Example
A company, Green Co., provides credit sales to customers. During a financial year, the company sells goods worth $100,000. However, the company believes $5,000 of this balance to be irrecoverable. On top of that, Green Co. also estimates $3,000 to be doubtful. Therefore, the company must record these debts as bad and doubtful, respectively.
For the bad debts, Green Co. uses the following journal entries.
| Dr | Bad debts | $5,000 |
| Cr | Accounts receivable | $5,000 |
For the doubtful debts, Green Co. uses the following double-entries.
| Dr | Doubtful debts | $3,000 |
| Cr | Allowance for doubtful debts | $3,000 |
Conclusion
Bad debts are an expense in the income statement that relates to amounts owed by customers. When a customer fails to repay, the debt becomes irrecoverable. For that amount, the company must write off the bad debts. Similarly, companies must also estimate doubtful debts and record them in the income statement.
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