Bad debts expense is an accounting term that refers to accounts receivable entries that have been determined as non-collectible or irrecoverable debts.
To understand how bad debts affect accounting records, consider the history of entries in the company’s ledgers. In many cases, businesses sell their goods or services to customers on 30-day or 60-day credit terms. This serves as an incentive for customers to make the purchase and take delivery, but payment will be made at a later date. Not all customers will make the payments as agreed, and some will not be able to make payments at all. When the seller determines that the debt is irrecoverable, the entry will be tagged as a bad debt, and records will be adjusted to show the amount as an expense.
Bad Debts as Account Receivables
Initially, the transaction is reflected in the books as a credit entry in the sales ledger while an equivalent amount is debited from accounts receivable. These entries remain on the books until payment is received or nonpayment is noted. When payment is made, the cash account is debited and accounts receivable shows a credit of the same amount. When the debt is determined to be non-recoverable, it may be written off using the direct write-off method or the allowance method.
Direct Write-off Method
The direct write-off method is straightforward. The bad debt account is identified, and accounts receivable is credited. An account called bad debts expense is debited with the same amount. Note that posting these entries will not reduce the sales figures, but it will certainly increase expenses.
The Allowance Method
Under the allowance method, seller assumes, based on experience and understanding of business cycles, that not all debt will be collected. As such, for every sales transaction posted, a predefined percentage of the sale is set aside and entered as a debit to bad debt expenses. A credit to the allowance for doubtful accounts is also entered without affecting sales figures.
Bad Debts vs. Doubtful Debts
Bad debt refers to an account that can no longer be recovered due to bankruptcy for instance. A doubtful debt is entered as an accounts receivable item, but it is anticipated that this account may turn into a bad debt later. Of course, no one really knows which accounts will turn into nonrecoverable items. Even so, create a reserve account that will be credited with the estimated amount of bad debt expenses regularly. The allowance for doubtful accounts represents your estimate of potential bad debts. Create a credit based on your estimate of bad debt figures, and debit the bad debt expense account.
The allowance method is considered the better method to post and report bad debt amounts. Under this method, part of the sales amount is reserved simultaneous with initial revenue posting. This means that income and expenses related to the income are reported in the same accounting period. In contrast, with the direct write-off method, revenue and relevant expenses may be posted in different accounting periods.
Bad debt expenses are incurred as part of the costs of doing businesses. Selling on credit is a viable strategy for businesses to increase sales, but be prepared with a plan to manage your accounts receivables based on generally accepted accounting principles.