Bad debt expenses are the losses suffered by a business due to non-payment of outstanding dues. Read on for more information on this and the methods employed by businesses in estimating bad debt.
Bad debt in a business is related to business debt. A business debt is the money owed to the business by another party, either individual or group. This outstanding amount that the outside party has to pay to the business, is known as the accounts receivable.
In the balance sheet, the entry for accounts receivable is made under the 'Current Assets' of the business. If for some reason, the outside party is not able to pay this outstanding amount to the business, it is termed as bad debt. Now let's find out about bad debt expense and how to estimate it.
Bad debt expense is the non-collectible accounts receivable in a specified period. In the balance sheet, net account receivables are calculated as the difference between the gross accounts receivable and the allowance for bed debts.
For example, if the gross receivables is USD 200,000 and the allowance for bad debt amount is USD 20,000, then net receivables are calculated as USD 200,000 - USD 20,000 = USD 180,000.
However, if the actual amount exceed the allowance for bad debts i.e. they are more than USD 20,000, say like USD 30,000, then, the difference between actual bad debts and allowance for bad debts i.e. USD 30000 - USD 20000 = USD 10000 is written off as bad debt.
Reasons for Bad Debt
A business incurs bad debt on two accounts. Firstly, if a sale is made and the customer is not able to pay for it within a predetermined time period. Secondly, if another business which owes money to the business is not able to pay up due to various reasons such as bankruptcy.
Estimating Bad Debt
Bad debts are a loss of revenue for a business, so they are shown as an expense in the company's income statement.
Businesses adopt the practice of estimating bad debt for the current period based on the expenses that have incurred in the previous time periods. After estimating it for the current period, the businesses make a bad debt allowance. This method is known as the Allowance Method.
In the US, allowance for doubtful accounts method is compulsorily followed by all businesses as it comes under U.S.GAAP i.e. Generally Accepted Accounting Principles.
Under this method, a reserve for bad debts is to be created every year. The reason behind this is "Matching Principle of Accounting". According to the matching principle, all the revenues and the expenses which a business incurs, have to be recorded in the same time period.
When a business makes a sale, the amount of money that it is going to receive from that sale falls under the 'Accounts Receivable' head.
However, there is a risk that the customers might not be able to fully clear the outstanding dues. So the entry for revenue generated from the sale has to have a provision for non collectible amount. This non collectible amount is thus presented under "Allowance for Bad Debts".
Bad debts which actually occur at the end of the year are subtracted from this 'Allowance for Bad Debts' and is termed bad debt. Take an example. A company has an accounts receivable of USD 100,000. If a company estimates its bad debts at 2% of the accounts receivable, then it makes an allowance for bad debts to the tune of USD 2000 i.e. 2% of 100,000.
But if the actual debt calculated at the end of the fiscal year is USD 3000, then the difference between the allowance for bad debts and the actual debts incurred i.e. USD 3000 - USD 2000 = USD 1000 is written off as the bad debt expense.
Thus, the entry for this is made in the income statement and shown under 'Allowance for Bad Debts' in the income statement.
An amount equivalent to bad debts is credited to the 'Allowance for Bad Debts' in the accounting books. It is a loss to the business and its stockholders. Hence, debt management is essential for any business. Besides that it is always good to make a provision for bad debts beforehand, to save the business from any unpleasant, unforeseen losses.