Bad Debts Meaning
Bad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions in between two parties either on account of sale of goods or services or repayment of any loan or other obligations as agreed under any predefined contract in between two or more parties.
Types of Bad Debt
Although there are no predefined types which any business can incur still we may classify according to different business models in the following category:-
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For eg:
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- Traders – A business entity that sells and purchases goods on credit may incur bad debts in case his/ her customer didn’t oblige to predefined sets of terms and conditions of payment for the purchase of goods.
- Service Providers – Similar to a trader, a service provider may also incur bad debts loss in case his/ her client does not repay fees for utilizing service providers services.
- Repayment of Loan – For a person engaged in providing loans, if a receiver didn’t repay his her dues, this will also amount to bad debts.
- Court Order – In case of a running dispute where out of court/tribunal or any judicial authority, an order is pronounced directing one party to pay another but still if the party doesn’t repay, this will also lead to the creation of bad debts (in case no other legal remedy is available).
How to Recognize Bad Debts?
There are two methods of accountingMethods Of AccountingAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods.read more for bad debts –
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For eg:
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- Direct Recognition Method: – Accounted as and when incurred;
- Provision for Bad Debts: – Estimation of a certain amount which will be incurred as bad debts.
Examples of Bad Debts
Now let us understand the examples and their accounting effect.
Example #1
Mark and Louis run a supermarket where goods are sold on both a cash and credit basis. During April 2019, Mark and Louis sold goods worth Rs. $ 20,00,000 to Larry trading corporation on credit periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy.read more of 100 days. During May ’19 Larry trading corp was declared as an insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.read more. During Sept’19, under the bankruptcy procedure, it is estimated that only 20% of the claim amount can be realized.
Based on the above data, provide the number of bad debts for Mark and Louis. Also, provide accounting treatment in books.
Solution
Based on a given set of data, the first set of accounting will be booking of sales of $20,00,000 and creating debtors in books. Next, during May, since the debtor was declared bankrupt, the full amount should be declared as bad debts. Lastly, since sept’19, it is estimated that 20% of the claim can be realized, it should again be booked as income.
Bad Debt Accounting Journal Entries are as follows: –
Example #2
Tony trading corporation shares the following details of his debtors and realization based on past trends.
| Particulars | Amount ($) |
|---|---|
| Sales During April’19 | 5,000,000 |
| Bad Debts Trend | 5% |
| Provide Journal entries with respect to bad debts accounting treatment if: – | |
| (A) Actual Realisation | 4,700,000 |
| (B) Actual Realisation | 4,750,000 |
| (C) Actual Realisation | 4,800,000 |
Solution
Since Tony trading corp. has a predefined set of an estimate having 5% bad debts ratio, he will be maintaining provision in the same percentages-
Bad Debt Accounting Journal Entries are as follows: –
Advantages
Bad debts in itself do not have many advantages, but yes, its recognition ensures correct accounting treatment at the correct time. It ensures recognition of expense in a period where it is incurred and hence enabling in ensuring principles of matching concept and revenue recognition.
Disadvantages
- It adversely affects the net realization of any business, i.e., it reduces the number of cash proceeds.
- It has an adverse effect on working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)"read more as it tends to reduce net receivables.
- If bad debts are not planned, and the organization does not create its provisions, then it tends to disturb the planning of fund managementFund ManagementFund management is the process of a company taking a person's, company's, or another fund management company's financial assets (generally high net worth individuals) and investing them in companies that use those funds as an operational investment, financial investment, or any other investment in order to grow the fund.read more.
- It also reduces the net worth of businessNet Worth Of BusinessThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus.read more as bad debts are nothing other than a loss of assets.
- It tends to increase the cost of funds involved in the business.
- Loss from a significant customer/ group of customers may even lead to the bankruptcy of an organization.
Important Points
- In today’s world, there are wide changes happening in business models, which have led to the emergence of new business models. Now business entity can also ensure its debtors on the payment of nominal fees.
- Not only insurance of debtors, but also there is an emerging business where business entities also buy other organization debtors and pay upfront or after realization from the third party. This business is commonly known as factoring.
- With the changing applicable laws and regulations, there are wide changes in accounting, recognition, and reporting of bad debts—an organization to adhere to all the norms and regulations. E.g., changes in IFRS, GAAP provisions, etc.
Conclusion
It can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions between two parties. Every business organization can incur bad debts, whether it is a trading firm, service provider, banking and other lending institutions, etc.
Bad debts adversely affect any business organization since it is nothing but an unforeseen loss of working capital. In today’s world of diversified business models, factoring business has emerged as excellent debtor insurance since it provides a certainty of net realizations on the payment of certain fees.
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