Bad Debts

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Bad Debts Meaning

Bad debts are credits that businesses extend to customers, but the repayment of which seems uncollectable. In short, when the repayment is irrecoverable, the debt is bad. Such incidents occur when customers experience financial turmoil and struggle to repay the outstanding amount to businesses. 

Bad Debts

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Credits, however, are not always bad. They are good when businesses extend credit to customers, and the latter repays on time. These turn bad only with the non-recovery of the due amount within the promised period. Recording these debts is crucial as the repayment is uncertain until received.

Key Takeaways

  • Bad debt refers to the extended credit that businesses offer customers, which they fail to repay within the promised tenure.
  • It adversely affects any business organization being identified as an unforeseen loss of working capital.
  • These are irrecoverable receivables considered an expense in a journal entry for bad debts.
  • The uncollectable debts are recorded using either direct write-off or provision/allowance.

Bad Debts Explained

Bad debts are irrecoverable receivables. Businesses extend credit to customers after verifying credentials and expect the repayment within the specified tenure. When this outstanding amount becomes uncollectable, such debts are classified as bad. The events of defaults are identified when customers delay or miss consecutive repayments.

While delayed or missed payments result from the customers’ changing financial capabilities, there are instances where recipients intentionally skip repayments. In addition, when lenders offer loans to seekers who are incapable of repaying, it also leads to irrecoverable debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more. The instances can occur anywhere, including trading, loans, etc.

In trading, businesses can allow customers to pay for goods and services later. Though many of them stick to the tenure and pay off before the deadline, some skip it intentionally and escape. On the other hand, when people take up loans from banking and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more, they borrow huge amounts and default on repaying the installments, calling for legal actions against them. 

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Recognition

Bad debts are recognized as expenses for a business as the recovery is doubtful until the customer repays on time. While the consecutive delays and misses detect the increasing chance of defaults, there are statistical methods that analysts use to compare historical data throughout the years of operation of a business. Then, they figure out the chances of the debts likely to turn bad for a business based on their analysis.

Businesses consider a percentage of net salesNet SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross sales.read more to identify the debts with chances of turning bad. This is done based on the history of the company with irrecoverable debts. Companies, therefore, keep introducing and transforming allowance for suspicious accounts. The allowance amount is credited with respect to the revenue generated, which is recorded as a debitDebitDebit represents either an increase in a company’s expenses or a decline in its revenue. read more.

Bad Debts Accounting

A bad debts expense is recorded using two accounting methodsAccounting MethodsAccounting 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 – direct write-off and provision or allowance. While small businesses with a cash basis of accounting use the former, those with an accrual accounting basis opt for the latter.

bad debts accounting

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Direct Write-Off

The bad debts to be written off are instantly recorded. This is the method applied as and when businesses identify such debts on the accounts. The irrecoverable amount, in this process, becomes a debit on the expense side, and it is the credit for the accounts receivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more section.

Allowance/Provision For Bad Debts

A bad debt provisionBad Debt ProvisionA bad debt provision refers to the reserve made by a company to set aside an amount computed as a specific percentage of overall doubtful or bad debts that has to be written off in the next year.read more is meant for the extended credits that seem irrecoverable. The financial analystsFinancial AnalystsA financial analyst analyses a project or a company with the primary objective to advise the management/clients about viable investment decisions. They do a thorough financial analysis and make suitable objective projections to arrive at their conclusions.read more in a firm recognize the doubtful debts and estimate the amount that might not come back to them. Once the irrecoverable amount is identified, they debit the bad debt expense while filling the credit side with the same amount for the irrecoverable debt provision contra account.

It is important to know that the write-off method does not comply with generally accepted accounting principlesGenerally Accepted Accounting PrinciplesGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more (GAAP). Therefore, businesses using GAAP for their accounting must opt for the other option, i.e., provision/ allowance.

Examples

Let us consider the following examples to understand the concept better:

Example 1

Mark and Louis run a supermarket where goods are sold on both cash and credit basis. In April 2019, they sold goods worth Rs. $ 20,00,000 to Larry Trading Corporation on a 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. In May ’19, the latter declared bankruptcyBankruptcyBankruptcy refers to the legal procedure of declaring an individual or a business as bankrupt.read more. Later, in September 2019, under the bankruptcy procedure, it was observed that only 20% of the claim amount could be retained, which showed signs of recovery after write-offWrite-offWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more, making it an income.

Based on a given set of data, the entries made looked like this:

It is important to know that the write-off method does not comply with generally accepted accounting principles (GAAP). Therefore, businesses using GAAP for accounting must go to the other option, i.e., provision/ allowance.

Bad Debts Example 1

Example 2

Tony trading corporation shares the following details of his debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. read more and realization based on past trends.

ParticularsAmount ($)
Sales During April’195,000,000
Bad Debts Trend5%
Provide Journal entries with respect to bad debts accounting treatment if: –
(A) Actual Realisation4,700,000
(B) Actual Realisation4,750,000
(C) Actual Realisation4,800,000

Since Tony Trading Corp. has a predefined set of an estimate having a 5% bad debts ratio, it will be maintaining provision in the same percentages-

The entries are as follows: –

Example 2.1

Recovering Irrecoverable Debt

Bad debt recovery is the recovered outstanding amount after being written off or previously considered irrecoverable. As companies already record them as losses, they become their earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more when received. There are multiple ways in which these irrecoverable amounts can be collected.

Businesses can have an in-house or third-party entity to collect the due amount. In addition, they can take legal actions and issue court orders to get back their extended credit. Above everything, a business lending an amount to another party can make it collateral-based. As a result, it secures the loanLoanA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more amount against the property of the recipient. In that case, companies can sell the property if customers default.

Frequently Asked Questions (FAQs)

What is a bad debt?

It is that extended credit that businesses offer to customers, but the latter fails to repay on time. It has an adverse effect on working capital as it reduces net receivables. If such debts are not planned and the organization does not create its provisions, it tends to disturb the planning of fund management.

Is bad debt an expense?

Yes, it is an expense or loss for a company. It is due to the failure of customers to repay the lenders or businesses. When something that a business offers as credit seems never to come back, it is recorded as an expense.

How to reduce bad debts?

These irrecoverable debts can be taken care of by introducing some effective ways or measures. For example, businesses can introduce discounts for early payers. In addition, they can secure their finances against collateral. Finally, companies or lenders can sell the property backing the amount to get their extended credit back in case of defaults.

This is a guide to what are Bad Debts and their meaning. Here we explain how they affect a business along with the accounting process and examples. You can learn more about accounting from the following articles –