Accounting for bad debts
In any business organization the transactions are carried out mainly in two ways:-
• cash basis
• credit/accrual basis
In case the business is carried out on cash basis, there is no problem regarding the payments as transactions are completed as and when they occur. Money is paid then and there. But in latter case, i.e, credit basis, there may be a chance of non payment or non recovery. That part of receivables which is left unrecovered is known as bad debt. In simple words the debt which has turned bad, i.e, irrecoverable.
Accounting Process:
The accounting process in both cases differs.
• In case of cash transactions the incomes are recorded as and when the transaction takes place.
• In case of credit terms, however, the transactions are recorded in the name of debtors and income is recorded only when they are received. As it happens in almost all businesses, there is a chance of non payment and hence a provision needs to be made for the same.
Accounting for Bad Debts:
There are two ways of recording bad debts.
• Direct write-off: This involves a directly writing off the debts from the receivables account and hence in this case the accounts do not match. The principles of conservatism and matching concept are violated and hence this method is generally not adopted.
• Allowance method: since this method is according to GAAP, it is most widely used and accepted. Here, the revenues are match to the expenses and the principle of conservatism is also taken into consideration.
Direct Write Off:
In this method the debts are considered bad only when the customer fails to pay and it is certain that there will be no recovery. Its favorable point is that it is based on facts and not on estimation. The accounting involves debiting the bad debts account and crediting debtors/receivables account. Though the method is based on actual occurrence of bad debts, it is not accepted for reporting and accounting because it fails the principle of matching revenues with expenses.
Allwance Method:
In every business there are certain customers who default in paying their dues and hence lead to losses of revenue. In order to cushion the business from such instances, a provision is made in the income statement. It is important to note here that the accounting for bad debts is done at the end of the year and is made as an adjustment entry in the income statement.
The amount of provision made maybe calculated on the basis of:
• past records of debtors/receivables or
• Made as a fixed percentage of the debtors.
Provision created for bad debts should be of reasonable amount since it is made out of the profits.
Enteries in the Books of Accounts:
When the provision is made, the income statement/ profit and loss account is debited and the provision appears in the balance sheet on liabilities side under the head of current liabilities and provisions. Or it is deducted from the debtors on the asset side. When all efforts of recovering the debts have failed and reasonable time period has passed, the debt is then considered irrecoverable. When a bad debt actually occurs, that is known as bad debt expense, an adjustment entry is made. In income statement, the provision is reduced to the extent of bad debt expenses and corresponding entries are made in the balance sheet. It is important to note here that the effects in P/L account and balance sheet will only be correctly made if the journal entries are correct. In case of actual default the provision account is debited and debtors account is credited. The effect of adjustment entry is shown in both the statements- P/L account and balance sheet, as explained earlier.
Recovery of Bad Debts:
In very rare cases, the defaulting debtor clears his unpaid (considered as irrecoverable earlier) debts. In such cases entries have to be made to account for the income. Here, the receivables/debtors account is debited and the provision account is credited. It is a reverse entry of the previously made entry. Another entry is made- cash account debited and debtors account is credited- to account for the cash received.
Importance of Provision:
After discussing the accounting practices for bad debts, it is important to discuss the reason for making provisions and maintaining the accounts correctly. GAAP, i.e., Generally Accepted Accounting Principles, clearly states the need for conservatism and following the concept of matching revenues with expenses. The principle of conservatism is the basis for creating the provision for bad and doubtful debts. Since the debts do not become expense immediately, they are also called doubtful debts. The provision helps business organizations in creating a cushion for itself against bad debt expenses and future losses there from.
Since creating provisions involves additional entries in the journal, it is important to understand the process and implement it correctly. Any mistake may lead to differences in the balance sheet which would require further time and efforts to be corrected. The key is to follow the process step by step and balancing the statements accordingly. The calculation of provision amount also requires due care. The methods of the same have been discussed earlier and importance is again emphasized here. The provision created should be of such an amount that neither is too large nor too small. Since the amount is appropriated from the revenues of the business, it is imperative that the provision does not exceed to an extent which maybe considered as a drain on the resources. At the same time, it should not be so small such that the bad debt expenses actually incurred exceed the provision. In such situations there are losses to the business despite of the provision. Hence, amount of provision is as important as creating the provision itself.
Conclusion:
The accounting practices discussed above are relevant for almost all kinds of businesses, yet the actual practices may differ depending upon the conventions followed and the unique nature of the business. Though all the relevant matter regarding accounting for bad debts has been discussed, the following are the related topics which might interest the reader:
• Taxability of bad debts
• Credit control and minimization of bad debts
• credit rating
• collection of bad debts
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