Understanding Bad Debts Journal Entry

Bad debt journal entries are financial transactions that record the recognition of uncollectible accounts receivable. These entries help in maintaining accurate and transparent financial records, ensuring that a company's financial statements reflect the realistic value of its potential revenue. Bad debt is an account receivable type for an organization that becomes uncollectible from customers due to the inability of the customer to repay the amount taken on credit. In this article, we will be discussing the Bad Debts Journal Entry in detail with examples.

Table of Contents

• What is bad debt?
• Types of bad debts
• Examples of Bad Debts Journal Entry
• Bad Debts Adjustment in Final Accounts
• Bad Debt Expense Write-Off Methods
• How to Write-Off Bad Debt?

What is Bad Debt?

Bad debt is an amount of money that the creditor should write off as a result of a default on the debtor’s part. When the creditor has bad debt on books, it becomes uncollectible and recorded as a charge-off. It refers to a contingency that must be accounted for by every business offering credit to customers. 

Such entities estimate how much of the receivables may become uncollectible by using the accounts receivable (AR) aging method or percentage of sales method. The business views bad debts as expenditures since there is less probability of generating revenue from these debts. 

When goods are sold on credit, a situation where some of the customers may fail to pay the amount may arise due to insolvency. Since this amount remains unrecovered, it becomes a bad debt. Whenever the bad debts are recovered, it is known as the bad debts recovered. 

Types of Bad Debts

The following are the types of bad debts:

1. Auto Loans: It is considered to be bad debts since the value of a vehicle depreciates over important. The car value depreciates due to service history, fuel economy, warranty period, etc. 
2. Personal Loans: Such loans have a very high rate of interest, due to which it is very easy to fall into the debt trap. If you do not repay the loan on time, then it can pile up before time.
3. Loan Shark Lenders: These are loan providers that offer loans in the unorganized sector at very high rates. This interest rate is often quite above the legal standard. It makes working with lenders against the law. 
4. Payday loans: It is one of the worst types of bad debts which are short-term and unsecured loans. The interest rates are extremely high upto as 400%. Due to late fees and multiple services, any miss of the repayment dates can quadruple the debts. 

Example of Bad Debts Journal Entry

Bad Debts Journal Entry is shown below. Let us consider the example of Anuj who owes ₹10,000. He has become insolvent due to which this amount has become insolvent. From his property, only 70 paise has been recovered.

Let us suppose that out of the bad debts worth ₹ 10,000, ₹ 3000 is the bad debt recovered.

Bad Debts Adjustment in Final Accounts

Information about bad debts present outside the trial balance is included before adjustments in final accounts. If these adjustments are not made during the preparation of financial statements, numbers in the firm’s final accounts will be inaccurate. Let us now consider including Bad Debts into Financial Statements.

• Situation 1: When bad debts are included in trial balance, no adjustment is made. In such cases, P&L is affected.
• Situation 2: Final accounts are adjusted in case bad debts are given outside trial balance as the supplement information that is called as further bad debts. 

Bad Debt Write-Off Methods

A bad debt write-off occurs when a company determines that a specific customer account will not be paid and removes the amount from its accounts receivable. There are mainly two methods to write off debt:

1. Direct Write-off Method

It is the most straightforward approach in which the debt is removed directly from the company's books when it is deemed uncollectible. It is mostly used by smaller businesses or for individually significant accounts. Here, bad debt is directly written off to a receivable account. While the bad debts account is debited, the accounts receivable account is credited. Although through this method, the exact amount of uncollectible debt is recorded, it does not follow the matching principle of accrual accounting. It is not the most accurate method to theoretically determine bad debts.

Accounting Process

When writing off a bad debt, two journal entries are typically made:

1. A debit to Bad Debt Expense
2. A credit to Accounts Receivable

Example Scenario Let's say a company has a ₹1,000 outstanding invoice from a customer:

• When it becomes clear the ₹1,000 won't be paid
• Journal Entry:
  • Debit Bad Debt Expense: ₹1,000
  • Credit Accounts Receivable: ₹1,000

Limitations

• Can distort financial statements if used inconsistently
• Doesn't match the revenue to the period when it was earned
• May not accurately explain the company's financial health

2. Allowance Method

Many larger businesses prefer the allowance method which estimates potential bad debts in advance. In this method, a contra asset account or Allowance for Doubtful Accounts is created. This method is helpful in managing uncollectible accounts. This method is used when a large amount of money is involved. The organization anticipates that bad debts will occur and prepares accordingly. An allowance for doubtful accounts is created. This is a contra-asset account and reduces loan receivable accounts when both accounts are listed in the balance sheet.

Tax Implications

• Bad debt write-offs can be tax-deductible
• Businesses must follow specific Income Tax Department guidelines
• Proper documentation is crucial for tax purposes

When Should Bad Debt Be Written Off?

Bad Debt should be written off in the following scenarios when:

• The customer has declared bankruptcy
• Debt is significantly past due (often after 90-180 days)
• Cost of collection exceeds the debt amount
• Legal action is deemed unprofitable

Comprehensive Example Imagine a scenario:

• Joe's Electronics sells ₹1,500 worth of computer equipment to a small business
• After 18 months of non-payment and failed collection attempts
• The company determines that the debt is uncollectible.

How To Write Off Bad Debt?

There is a direct write-off method for bad debts. The method involves directly writing off to the receivables account. Under this method, bad debt expenses serve as direct loss from uncollectible. This goes against revenues resulting in lowering income. Let us see how it is done.  

Conclusion

When payments from sundry debtors are accepted when their accounts have been written off as bad debts, it is known as the recovery of bad debts. Bad debts journal entry in case of recovery must reflect that it is treated as a gain for business as contrary to bad debts written off. When recording the received money, the debtor should not be credited as in the case of sales.