Recording uncollectible debts will help keep your books balanced and give you a more accurate view of your accounts receivable balance, net income, and cash flow. For example, the company ABC Ltd. had the credit sales amount to USD 1,850,000 during the year. Based on past experiences and its credit policy, the company estimates that 1% of credit sales which is USD 18,500 will be uncollectible. An additional journal entry will be recorded to balance off the contra account of allowance and write-off receivables.
When a company makes a credit sale, it books a credit to revenue and a debit to an account receivable. The problem with this accounts receivable balance is there is no guarantee the company will collect the payment. For many different reasons, a company may be entitled to receiving money for a credit sale but may never actually receive those funds. In that case, you simply record a bad debt expense transaction in your general ledger equal to the value of the account receivable (see below for how to make a bad debt expense journal entry). Bad debt expenses make sure that your books reflect what’s actually happening in your business and that your business’ net income doesn’t appear higher than it actually is. Accurately recording bad debt expenses is crucial if you want to lower your tax bill and not pay taxes on profits you never earned.
Financial Management: Overview and Role and Responsibilities
Calculating your bad debts is an important part of business accounting principles. Not only does it parse out which invoices are collectible and uncollectible, but it also helps you generate accurate financial statements. With respect to financial statements, the seller should report its estimated credit losses as soon as possible using the allowance method. For income tax purposes, however, losses are reported at a later date through the use of the direct write-off method.
- In the scenario discussed above, the matching principle is exploited.
- On the other hand, the allowance method accrues an estimate that gets continually revised.
- Though part of an entry for bad debt expense resides on the balance sheet, bad debt expense is posted to the income statement.
When you heard the word ‘bad debt,’ you might wonder if there is any good debt too? Because all of us have a general perception that debt is a bad thing. If the company’s Accounts Receivable amounts to $3,400 and its Allowance for Bad Debts is $100, then the Accounts Receivable shall be presented in the balance sheet at $3,300 – the net realizable value. We have explained the reasons and criteria for the deduction of bad debts.
How to record a bad debt expense
A bad debt expense is a portion of accounts receivable that your business assumes you won’t ever collect. Also called doubtful debts, bad debt expenses are recorded as a negative transaction on your business’s financial statements. You only have to record bad debt expenses if you use accrual accounting principles. This is the case, where the company follows the direct write-off method. Every business has its own process for classifying outstanding accounts as bad debts. In general, the longer a customer prolongs their payment, the more likely they are to become a doubtful account.
At a basic level, bad debts happen because customers cannot or will not agree to pay an outstanding invoice. This could be due to financial hardships, such as a customer filing for bankruptcy. It can also occur if there’s a dispute over the delivery of your product or service. To make the topic of Accounts Receivable and Bad Debts Expense even easier to understand, we created a collection of premium materials called AccountingCoach PRO.
How to Estimate Bad Debt Expense
Sometimes, at the end of the fiscal period, when a company goes to prepare its financial statements, it needs to determine what portion of its receivables is collectible. The portion that a company believes is uncollectible is what is called “bad debt expense.” The two methods of recording bad debt are 1) direct write-off method and 2) allowance method. This expense is called bad debt expenses, and they are generally classified as sales and general administrative expense.
Why bad debts happen
Now that you know how to calculate bad debts using the write-off and allowance methods, let’s take a look at how to record bad debts. Allowance for bad debts (or allowance for doubtful accounts) is a contra-asset account presented as a deduction from accounts receivable. Consider a company going bankrupt that can not pay for all of its bills. Some of the people it owes money to will not be made whole, meaning those people must recognize a loss. This situation represents bad debt expense on the side that is not going to collect the funds they are owed. Because no significant period of time has passed since the sale, a company does not know which exact accounts receivable will be paid and which will default.
What is a bad debt expense?
So, an allowance for doubtful accounts is established based on an anticipated, estimated figure. Offer your customers payment terms like Net 30 and Net 15—eventually you’ll run into a customer who either can’t or won’t pay you. When money your customers owe you becomes uncollectible like this, we call that bad debt (or a doubtful debt).
What is Bad Debt?
The major problem with the direct write-off is the unpredictability of when the expense may occur. Consider a company that has a single customer that has a material amount of pending accounts receivable. Under the direct write-off method, 100% of the expense would be recognized not only during a period that can’t be predicted but also not during the period of the sale. But this isn’t always a reliable method for predicting future bad debts, especially if you haven’t been in business very long or if one big bad debt is distorting your percentage of bad debt. Like any other expense account, you can find your bad debt expenses in your general ledger. The percentage of the receivable method also encompasses the historical value of bad debts in the past years.
