Bad Debt Expense Journal Entry
The journal entry for bad debt expense is a crucial accounting process that ensures accurate financial reporting and a strong financial position for a company.
What Is Bad Debt Expense Journal Entry?
The journal entry for bad debt expense is a crucial accounting process that ensures accurate financial reporting and a strong financial position for a company.
It involves determining the amounts that cannot be collected from consumers and appropriately reflecting them on the balance sheet.
While historical data, such as the company's past success in recovering loans, is a significant factor in assessing bad debt, it is not the sole criterion for removing the debt from accounts receivable.
The decision to recognize bad debt is based on a comprehensive evaluation of various factors that affect the likelihood of collecting outstanding debts.
Historical data, including the percentage of accounts receivable due within 30 days and accounts receivable outstanding for less than 30 days, serves as a valuable reference point to gauge the company's past debt recovery performance.
However, the ultimate determination of bad debt considers ongoing collection efforts and the assessment of the debtor's ability and willingness to pay.
Factors like communication with the debtor, the debtor's financial situation, past payment history, and any legal or regulatory considerations are taken into account in this evaluation.
By combining historical data with current assessments, the company ensures a more accurate representation of its bad debt expense.
Recognizing bad debt as soon as it becomes evident upholds the integrity of financial reporting, providing stakeholders with reliable information about the company's financial status.
These calculations heavily rely on the company's historical track record. As a result, bad debt is estimated as an amount that is unlikely to be collected from accounts receivable before collection efforts are exhausted.
If any of these "bad debt" amounts are eventually recovered, they are recorded under "recovery of bad debt." There are two primary methods for calculating and recording bad debt from accounts receivables: the direct write-off method and the allowance method.
Key Takeaways
- The journal entry for bad debt expense is a crucial accounting process that ensures accurate financial reporting and a strong financial position for a company.
- For each type of bad debt, specific accounting journal entries are required to account for and manage the financial impact properly.
- Methods such as accounts receivable aging, percentage of sales, and percentage of receivables can be used to calculate bad debt.
- Accurate recording of bad debt supports financial stability and informed decision-making.
What Are Bad Debts?
Bad or questionable debt is a form of account receivable. Accounts receivable are considered bad debt if the firm believes and has demonstrated past historical records that it will be unable to collect payment from the specific client.
When this happens, it is written as an expense on the income statement. There are various reasons why a corporation may be unable to collect a debt fully; these include payment disputes, bankruptcies, and even extending to clients who refuse to pay.
Bad debt is important as there is a fear that businesses might overstate their assets and/or their income despite not being able to collect full sums of account receivables. Therefore, companies dealing with others who owe them money, or individuals, might default.
Since there are no specific ways to calculate bad debt, dependent on estimates and assumptions, two primary ways of calculating it, percentage of sales and percentage of receivables, are used.
Bad Debt Direct Write-Off Method
Much like other accounting methods, the direct write-off method is methodical and structured. To this end, its steps are predefined and very clear in writing. A determination into which debts are problematic is made as a judgment by the accountant.
After this, before these debts are written off, information is gathered on items such as historical precedents and the client's credit score (in regard to account receivables payment). Lastly, a note is to be made on the balance sheet.
In the Direct Write-Off Method, the company records the bad debt as an expense on the income statement when it becomes evident that the specific account receivable is uncollectible.
For example, if a consumer owes $1,000 and the firm determines that they would not be able to recover the amount, the write-off item would be as follows:
| Account name | Debit | Credit |
|---|---|---|
| Doubtful debts expense | $1,000 | - |
| Accounts receivables | - | $1,000 |
| Total | $1,000 | $1,000 |
Entries in the ledger for a provision for bad debts
Assume a business has made $200,000 in credit sales and a $200,000 accounts receivable amount. Assuming a 10% reserve for bad debt is reasonable, the following journal entry is entered.
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 April | Bad debt expense | $20,000 | - |
| Bad debt provision | - | $20,000 |
The first account is an expense (income statement account), whereas the second account is a current liability (balance sheet account) (a provision).
Now, let’s assume that the following year, the company had an opening (brought forward) bad debt provision of $20,000. The company now thinks that a $25,000 bad debt provision is necessary.
The movement, or in other words, the increased provision, will be recorded on the income statement, not the total $25,000 amount. The journal entry to reflect the bad debt expenditure in this scenario would be
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 April | Bad debt expense | $5,000 | - |
| Bad debt provision | - | $5,000 |
Next, the $5,000 is cut if the corporation desires a $15,000 provision instead of a $25,000 provision. The following is the journal that is required to facilitate the provision for bad debts:
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 April | Bad debt provision | $5,000 | - |
| Bad debt expense | - | $5,000 |
A Journal entry is made to write off a provision for bad debt expenditure
If a receivable appears on your statement of financial position that you no longer deem collectible, you must write it off. Irrecoverable debts is the term that is used to describe this.
Note
The distinction between obligations and bad debts is that writing off bad debt reduces accounts receivable but does not affect the provision for bad debts.
For example, if a corporation made a $2,000 credit sale to a client who later went into liquidation, the amount may be written off. In this example, the journal goes as shown:
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 April | Bad debt provision | $2,000 | - |
| Bad debt expense | - | $2,000 |
Recovered but previously expensed bad debt is recorded in the Journal
Debts that are later paid are sometimes written off by businesses (recovered). If a business recovers a previously written-off amount, a journal must be recorded to reverse the profit and loss effect.
For example, if you can recover the $2,000 that was written off (see above), you would make the following entry:
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 April | Cash | $2,000 | - |
| Bad debt expense | - | $2,000 |
Bad Debt Allowance Method
Unlike the direct write-off method, the allowance method allows for the item to be immediately debited from the balance sheet from the account receivables. Moreover, no change is accorded to the income statement for bad debt (also called doubtful accounts).
If a customer owes $1,000 to the business, and the business has a total of $10,000 in accounts receivable, the following transaction will occur:
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 April | Allowance for bad debt | $1,000 | - |
| Accounts receivables | - | $1000 |
To write off bad debt (recovery of bad debt), the accounts reflected under the balance sheet will be reinstated. For instance, $1,000 was recovered in bad debt on 15 August:
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 August | Allowance for bad debt | - | $1000 |
| Accounts receivables | $1000 | - |
Increase the cash amount, and balance out the amount in accounts receivables (as it is now net zero after repayment):
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 August | Cash | $1000 | - |
| Accounts receivables | - | $1000 |
Note
The allowance method allows for in advance uncollectible amount inclusion, which is a more conservative outlook on assessing a business whereas the direct write-off method involves a more delayed approach in calculating bad debt.
Types Of Bad Debt Expense Journal Entries
Because there is no likelihood of providing any future financial advantage, a corporation considers its bad debts as costs. Writing it off helps the corporation save money during tax season while ensuring its assets' worth is not overstated.
When a corporation faces situations where there is no likelihood of receiving payment for outstanding debts, it considers these amounts as bad debts.
Writing off bad debts not only helps the corporation during tax season by reducing taxable income but also ensures that its financial statements accurately reflect the actual worth of its assets.
Note
There are various forms of bad debts, including personal loans, credit card debts, automobile loans, deals with moneylenders, payday loans, and non-payment by service providers and traders.
For each type of bad debt, specific accounting journal entries are required to account for and manage the financial impact properly. Let's explore the different journal entries for each type of bad debt.
Bad costs aren't assets, and writing them off helps the corporation to lower its accounts receivables report total. Lower accounts receivables indicate strong financial health, reflecting that the firm can efficiently recover payments.
There are several different forms of bad debts to consider, including the following below.
Loans for individuals
A personal loan is a sum of money that debtors borrow from creditors to cover personal expenses with money that the debtor is unwilling to spend at said point in time. This includes items such as medical bills, trips, or investments.
Personal loans such as credit cards have interest rates that fluctuate depending on your credit history, which looks at prior track records you have as a debtor.
The interest rates on these loans might range between 5% and 35%. Personal loans are normally repaid in monthly installments.
Note
It's critical to pay off this form of bad debt quickly; however, many choose to take between two and five years to repay their bad debts, depending on the amount.
Debt on a credit card
Customers are regularly given credit cards by lenders so that they may make purchases. These cards may have higher interest rates depending on the lender, which means that a consumer will have to pay more the longer it takes to complete the transaction.
The bad debt is the amount you owe on your credit card, not the card itself. To avoid incurring additional interest or fees, a cardholder must be diligent about spending within their financial means and paying off any obligations in a timely way.
Loans for automobiles
When buying a car at a dealership, it's typical for buyers to take out auto loans. A person might pay extra upfront to assist in reducing the interest rate they pay on a vehicle.
A vehicle's value depreciates over time due to various variables such as gas mileage, fuel economy, warranty term, and other conditional changes.
Note
The owner must choose the optimal moment to trade or sell their car to optimize their profit margins.
Deals with moneylenders
This sort of lender can waive both your credit report and your background check, making it easier to get a loan. Because you normally pay back the loan in a very short period, this sort of bad debt carries high-interest rates.
When dealing with a moneylender, it's critical that you pay off your bad debt as soon as you're able.
Payday loans are short-term loans
Payday loans are distinct from other bad debts in that they are short-term and often have interest rates of up to 400 percent. Aside from late and service penalties, high-interest rates encourage borrowers to repay their loans on time.
Note
Payday loans can help you avoid mounting debt and save you a large amount of money.
Non-payment by service providers and traders
If a trader sells an item or a service provider performs a service and the consumer does not pay, the trader or service provider may incur a bad debt. In these situations, a company may use debt collectors to help them recover the money they owe.
It's beneficial for them to be able to close out a bad debt on their financial accounts since it shows a history of prompt payment recovery. Investors use these facts to evaluate a company's profitability and reliability.
Accounts Receivable Aging Method
The accounts receivable aging method is one of the methods that can be used to calculate bad debt or uncollectible amounts receivable.
In this method, different receivables are grouped into receivables with different maturity dates (e.g., 30 days, 60 days). From there, an estimated number or percent of defaults is assigned to different mature groups.
As the groups increase in manner of maturity (i.e., the receivables take longer to reach maturity and return a payment to the business), the assigned percentage of default (expected) increases.
This means that the default percentage will be higher for 60 days (for instance) against the group with a maturity of 30 days.
For instance, take the example of a business with accounts receivables of $1,000,000 in its books. It can be further split into the dates when the accounts are due to be repaid to the business.
| Amount in question | Total amount - the amount in question | Assumed percentage of default (based on historical data) | |
|---|---|---|---|
| 30 days | $500,000 | $500,000 | 7% |
| 60 days | $300,000 | $700,000 | 9% |
| 90 days | $200,000 | $800,000 | 11% |
| Total amount | $1,000,000 | - |
From there, the bad debt percentage is assigned depending on historical data the business has had with past dealings, using purely time frames to account.
To calculate the bad debt, therefore:
(500,000 x 7%) + (300,000 x 9%) + (200,000 x 11%) = 84,000
Hence, the recorded bad debt will be $84,000 in the balance sheets.
Percentage Of Sales Method
Another method used to deduce bad debt amount, the percentage of sales method, uses data extracted from the income statement.
In this, the relationship that exists between the uncollectible amounts to sales is calculated. The probability of default based on prior years is compared against credit sales of past years.
Under this method, the company uses the credit sales of the current year to estimate the amount of bad debt, increasing or decreasing this based on circumstance (e.g., recessionary period, clients change) without relying on historical data.
Note
If the company engages in a sufficiently low or constant amount of cash sales, the historical numbers for default are instead compared against total net sales.
Assume that the company has $100,000 in net sales and has properly estimated its percentage of uncollectible receivables at 4%, then:
100,000 x 4% = 4,000
(Bad debt = Total net sales x percentage of uncollectible receivables)
Hence the bad debt expense would be $4,000.
In terms of accounting, the bad debt would be incorporated into the income statement.
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 August | Bad debt expense | $4,000 | - |
| Allowance for doubtful accounts | - | $4,000 |
| Accounts receivables | - | $100,000 |
| Less: allowance for doubtful accounts | $4,000 | - |
| Net accounts receivables | $96,000 |
Percentage Of Receivables Method
Where the percentage of sales method is used regarding the income statement, the percentage of receivables method is used regarding the balance sheet.
A desired size for the allowance for uncollected amounts (doubtful accounts) is calculated based on historical records for the company.
Next, the ending balance in accounts receivables is multiplied by an overall rate/age-dependent rate (see accounts receivable aging method). The formula below is then used to identify the respective bad debt expense:
Bad Debt Expense = (Accounts receivable x percentage of bad debt estimated uncollectible) – Existing credit balance in the allowance for doubtful accounts + existing debit balance in the allowance for doubtful accounts
Note
As bad debt expense is a debit item, the credit balance in the allowance for doubtful accounts is subtracted as it is a credit item. Debit items are added to form bad debt expenses with credit items subtracted.
Assuming the existing credit balance in the allowance for doubtful accounts is $100, the existing debit balance in the allowance for doubtful accounts is $200, accounts receivables have $5,000, and the percentage of bad debt estimated as uncollectible is 5%:
(5,000 x 5%) - 100 + 200 = 350
Hence, the bad debt expense is $350.
| Date | Account name | Debit | Credit |
|---|---|---|---|
| 15 August | Bad debt expense | $350 | - |
| Allowance for doubtful accounts | - | $350 |
| Accounts receivables | - | $5,000 |
| Less: allowance for doubtful accounts | $250 | - |
| Net accounts receivables | $4,750 |
As seen in the above example, unlike the percentage of sales method, the percentage of receivables method uses the desired allowance for doubtful accounts ($250) as the target benchmark.
Despite the adjusted entry allowance for doubtful accounts being $350, the amount that will be input into the balance sheet will always be the amount that the business seeks to get (in this case, $250).
To achieve this, the percentage of bad debt deemed uncollectible has to be modified to reach this amount, as the other variables are set. As this is the only variable the business controls, it can manipulate it to calculate the allowance for doubtful accounts.
Conclusion
In conclusion, accurately recording bad debt expenses through journal entries is crucial for a company to maintain accurate financial reporting and demonstrate a strong financial position.
Bad debt refers to accounts receivable that a company believes it will be unable to collect payment from, and it is important to identify and record these debts appropriately.
The two primary methods for calculating and recording bad debt are direct write-off and allowance methods. The direct write-off method involves determining which debts are problematic and gathering as much information as possible before writing them off.
This method involves estimating the percentage of default based on historical data and assigning it to different maturity groups of receivables.
It also helps identify accounts that have defaulted, enabling companies to develop strategies for resolving them and minimizing their impact.
By using appropriate methods and techniques, businesses can manage and mitigate the risks associated with bad debt, ensuring financial stability and success in the long run.
or Want to Sign up with your social account?