The sale of goods on credit plays an important role in the effective functioning as well as the long-term financial health of any business enterprise. Typically, credit sales form a significant chunk of a company’s total turnover as compared to cash sales.
Through credit facilities, a company can induce buyers to purchase higher quantities and thereby achieve economies of scale.
However, there are instances when a company is unable to collect these outstanding amounts. According to Investopedia, some of the reasons for default could be due to the debtor filing for bankruptcy, the inability to trace the debtor or fraud.
Once a debt is classified as uncollectible, generally, it is recorded on the debit side of the income statement and adjusted against provisions for bad and doubtful debts. A second effect can be observed in the company’s balance sheet when the currents assets are impaired, and bad debts are written off.
When is a Debt Considered Uncollectible?
The terms of credit sale may vary from one company to another. Generally, the credit period could range anywhere from 30 days to 90 days, depending on the creditworthiness of the debtor and industry practices.
Enterprises keep track of these receivables based on the outstanding number of days. However, if a debtor does not make any payments up to 90 days, these amounts could be classified as doubtful or worthless.
How Old Can a Debt Be Before It Is Considered Uncollectible?
In the United States, the Statutes of Limitations governs the collection period for outstanding debts. However, the timeframe may vary from one jurisdiction to another. Most often, in the case of business-related bad debts, they are for less than one year and are considered as loss incurred during operation.
Example Journal Entry for Bad Debts
Since bad debts are short-term contingencies that pertain to the current financial year, they can be classified as a revenue-type expenditure.
Two accounts are impacted when recording a bad debt expense – the debtor’s account and the bad debts account. Using the accounting principle for personal and nominal accounts, we debit all expenses and losses and credit the giver.
The accounting journal entry for recognizing bad debts is:
|2020||Bad Debts||$ 500|
|July, 27||Debtors||$ 500|
|Lack of customer payment|
Since bad debt is a loss for the business, it is recorded on the debit side of the income statement and adjusted against the current period’s income. The second effect will be the reduction in working capital by crediting the debtor’s account (or the Accounts Receivables).
How Does a Company Ascertain the Amount of Uncollectible Debts?
Estimating bad debt expenses can be a meticulous task for any company. A higher uncollectible estimate would raise questions on the effectiveness of the company’s credit policy. On the other hand, a low estimate could inflate the debtor and accounts receivable amounts in the balance sheet.
There are two methods for determining the amount of bad debts. The first is through the percentage of accounts receivable method, and the second is by using a percentage of sales method. These are the only two methods for poor debt estimation, as these charges are directly correlated to credit sales and debtors’ balances.
When using the percentage of accounts receivable, the company sets aside a provision for doubtful debt as a percentage of the outstanding receivables balance. For example: If the company expects 5% of uncollectable debts with a receivables balance of $10,000, then the provision for doubtful debts for that period would be $500 (5% of $10,000).
Likewise, when using the percentage of sales method, the company would calculate a provision for doubtful debts based on the total sales during the period. So, a 2% estimate for $50,000 credit sales would mean a $1,000 provision for bad debts.
Example of Business-Related Bad Debts
The best examples of a business-related uncollectible debt are the ones arising from credit sales. Suppose ABC Ltd. sold $20,000 worth of goods on a 90-day credit to XYZ Ltd. In ABC’s books of accounts, XYZ becomes a debtor.
During the credit period, ABC would maintain an aging schedule based on the number of days outstanding before the collection is due. However, if, during this period, XYZ files for bankruptcy and notifies ABC of the impending default, ABC has to recognize the contingency of bad debt.
Let’s assume that after XYZ’s bankruptcy proceedings are completed; ABC can realize $7,500 from XYZ’s liquidation process. In this particular case, even though ABC received a partial amount, the company still suffered a bad debt of $12,500.
As a result, ABC would recognize a cash inflow of $7,500 and debit the bad debt expense of $12,500 to nullify XYZ’s outstanding balance in its books of accounts. The accounting entry recording by ABC for this transaction would be:
|July, 27||Bad Debts Expenses||$ 12,500|
|XYZ Ltd||$ 20,000|
|Partial bad-debt written off|
Once you’ve finalized the account books, the bad debt expenses will be charged on the debit side of the income statement.
The Specific Charge Off Method
The specific charge off method, also known as the direct write-off, is the most commonly used approach to write-off uncollectible debts in the fiscal year. The company debits the bad debts expense and credits the accounts receivable to record the impact of worthless debt.
These bad debts are eligible for tax deductions only in the year in which they were deemed worthless. In the event of a partial write-off, the entire amount cannot be deducted until there is a default for the whole debt.
The Difference Between Reserve and Provision
Although they might sound synonymous, provision for bad debts and reserves for bad debts are distinct from each other. Provisions are an estimate of the reduction in the value of an accounts receivable recognized by the enterprise in its accounting system, whereas reserves are an appropriation of profits.
Since provisions for bad debts are determined based on forecasts, they could vary compared to the actual amount of bad debts. However, once the actual amount of bad debt is determined, they are set off against the reserve appropriated for bad debts expenses (or the reserve for bad debts).
Impact of Bad Debts on the Balance Sheet
The balance sheet is an accurate and fair indicator of the company’s financial position on a given day at the end of the financial reporting period. The balance sheet of a company must be adjusted to reflect the impact of bad debts.
Recognizing bad and doubtful debts leads to an offsetting transaction in accounts receivables or debtors’ balances, and these heads are reduced by the actual amounts of uncollectible debts.
Is It Possible to Write-Off on Cash Basis Accounting?
In the double-entry system (accrual system of accounting), every transaction has two impacts: a debit side and a credit side. If goods are sold on a cash basis, the company records an inflow of cash by debiting the Cash/Bank account.
Similarly, in the case of credit sales, the debtors or accounts receivables are debited. Once a collection is made, these accounts are adjusted to reflect an accurate and fair balance. This accounting treatment is applicable if the company recognizes accrued income from credit sales.
However, if a company follows a cash basis of accounting, there are two methods for writing off bad debts, i.e., by using a credit memo. In the first approach, the company can create a credit memo, to the tune of uncollectible debts, and reverse the original sale transaction. Alternatively, the enterprise may also record a credit memo as a bad debt expense and set-off the uncollectible amount in the profit and loss statement.
Business Bad Debts as a Tax Deduction
A business-related bad debt is an uncollectible debt arising out of routine business transactions. It is a deductible item when filing the business income tax returns under Schedule C (Form 1040). But the federal government allows this deduction only if it was previously included in the gross income while filing the taxes.
It can be claimed as an operating loss and can be subtracted from gross profits as a tax deduction. But if the books of accounts are maintained on a cash basis, bad debts cannot be claimed as a deduction, as all income is recognized only when received in cash.
What is an Allowance for Bad Debts?
The allowance for bad debts account is the amount which the management estimate of debts that will not be realized from the debtors. As they are contingent, the allowance for bad debts is reduced from the accounts receivable balance to show a true and fair picture of the company’s financial performance.
This account is created when the company follows an accrual basis of an accounting system. Allowance for bad debts is a contra account since it not only pairs with accounts receivables but also offsets the receivables.
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