What is Bad Debts
In reality, there are some situations where the company would not be able to recover the outstanding balances in relation to specific receivables. Such receivables are referred in accounting as bad debts or irrecoverable debts. Bad debts may occur due to several reasons such as bankruptcy, frauds or trade disputes. This article analyzes on how to deal with bad debts and the ways in which the impact of bad debts have been recorded in the accounting records.
How to deal with bad debts – Bad debts write off Method
There are primarily two methods of accounting for bad debts such as bad debts write off method and the allowance method. When a company recognizes that specific debts cannot be recovered from their receivables, they can be write off as bad debts from the accounting records. This is a line with the prudence concept. Accounting entry for writing off the bad debts can be illustrated as follows:
The amount of the bad debts is written off from the receivables account as it would not be possible to recover that amount from the receivables. The debit entry is to cancel off the bad debt amount in order to reverse the profits generated in the income statement.
For example, A Company sells out their goods to B Company for $500 on credit. As a result of B becoming bankrupt, there is a limited chance of recovering the due amounts. The double entry for bad debts can be recorded as follows:
How to deal with bad debts – Allowances for bad debts
There are some instances where previously written off bad debts can be settled either in full or part. In such situations, previously written off bad debts need to be cancelled off by the settled amount. This opportunity is provided by the company to their debtors with the purpose of recovering a considerable amount from the debts due.
For example, A Company sell their goods to B Company for $500 on credit. After a certain period, A Company finds out that B Company is becoming bankrupt, and there is a less opportunity of recovering the due amount and therefore decides to write off the amount from their receivables account. However, with regard to the prevailing situation they advised B Company to pay only the amount of $300 to settle the due amount in full. As the amount of $300 is recovered, it is essential to cancel the effect of bad debt expense by that amount and the double entry for the accounting records can be illustrated as follows:
- Needles et al (2011) Principles of Accounting, Nelson Education Ltd
- Edwards et al (2014) Accounting principles; A Business Perspective, Managerial Accounting, Global Text Project 2014