A bad debt relates to amounts that are owed to us and for which we think there is a high chance that they will not be paid. Bad debts also relate to amounts that we consider as not recoverable anymore. For example, if one of our customers goes into liquidation, then our receivable (the asset) that we have on your balance sheet might have to be written off.
It is important not to confuse the bad debt provision with the bad debts that are written off. The former is a provision that is created because we think that part of our receivables will not be paid (a general provision). The latter relates to specific accounts receivable balances that we think that will not be paid and will need to be written off.
Allowance for receivables and other bad debts
Companies often create a general provision for the amounts that their customers owe to them. Such provision are often calculated as a percentage of the total accounts receivable. For example, companies might think that 5% of the total accounts receivable might not be paid. Other companies prefer to use the aging of their debtors and create a provision based on that. For example, a company might choose to create a provision of 20% of the accounts receivable for debtors that are older than 90 days, 15% for debtors that are older than 60 days, 5% for debtors that are older than 30 days etc. There is no rule for the amount that each company should allow for and each company should create a provision based on the customers’ profile, the economic situation and the nature of the business.
Bad Debt Expense
When a provision is created, a journal will need to be posted. Explanations for the journals is provided below but briefly the bad debt expense is an income statement account where the movement in the bad debts along with the write off of the irrecoverable debts is posted.
The journal entries for bad debts
The journal entries that you will need to post depend on whether a general or specific provision needs to be created or whether a debt balance needs to be fully or partially written off.
Journal entries for a provision for bad debts
Let’s assume that a company has made $200,000 credit sales and therefore has a $200,000 accounts receivable balance. Let’s say that a 10% bad debt provision is considered as appropriate. In this case, the following journal will need to be posted.
Debit Bad Debts Expense $20,000
Credit Bad Debt Provision $20,000
The first account is included in the expenses (income statement account) while the second account is a current liability (a provision).
Now, lets assume that the next year,the company has an opening (brought forward) bad debt provision of $20,000. The company now thinks that the a $25,000 bad debt provision is necessary. It’s not the full $25,000 that will be posted on income statement but the movement or in other words that extra provision that is needed.
In this case, the journal that will be posted is the following:
Debit Bad Debts Expense (IS) $5,000
Credit Bad Debt Provision (BS) $5,000
If the company wanted a $15,000 provision instead of $25,000, then we would have to reduce the provision by $5,000. The journal that is necessary to reduce the bad debt provision is the following:
Debit Bad Debt Provision (BS) $5,000
Credit Bad Bad Expense (IS) $5,000
Journal entries to write off bad debts
If you have a receivable on your statement of financial position that you don’t consider as recoverable anymore, you will need to write it off. These balances are often called irrecoverable debts. The difference between these debts and the bad debts is that writing off bad debt will reduce the accounts receivable but will not affect the bad debt provision. For example, if a company made a credit sale of $2,000 to a customer that subsequently went into liquidation, writing off the balance might be appropriate. The journal in this case is the following:
Debit Bad Debt Expense (IS) $2,000
Credit Accounts Receivable (BS) $2,000
Journal entries for recovered but previously written off debts
Sometimes companies write off debts that are subsequently paid (recovered). If a company recovers a previously written off balance, then a journal will need to be posted to reverse the effect that the write off had on the profit and loss. For example, if the $2,000 that was written off (see above) is subsequently recovered, then the following entries will be made:
Debit Cash (BS) $2,000
Credit Bad Debt Expense (IS) $2,000