What is a bad debt?
Bad debts are expenses that a business incurs once the repayment of credit previously granted to a customer is estimated to be bad. Bad debts are a possibility that must be taken into account by all companies that extend credit to customers, as there is always a risk that payment will not be received.
Key points to remember
- Bad debts are an unfortunate cost of doing business with clients on credit, as there is always a risk of default inherent in granting credit.
- To comply with the matching principle, bad debts must be estimated using the provision method for the same period during which the sale takes place.
- There are two main ways of estimating a provision for bad debts: the percentage of sales method and the aging method of accounts receivable.
- Bad debts can be written off on corporate and personal income tax returns.
Understanding bad debts
There are two methods for recording bad debts. Using the direct write-off method, accounts are written off because they are directly identified as uncollectible. This method is used in the United States for income tax purposes. However, although the direct write-off method records the specific figure for accounts that have been determined to be uncollectible, it does not comply with the matching principle used in accrual accounting and generally accepted accounting principles (GAAP).
The matching principle requires that expenses be reconciled to related revenues during the same accounting period in which the revenue transaction takes place. Consequently, in accordance with GAAP, bad debt expenses must be estimated using the provision method for the same period during which the sale on credit takes place and appear in the income statement in the sales and administrative expenses section. general. Because no significant period of time has passed since the sale, a company does not know which exact accounts will be paid and which will be in default. Thus, an amount is established on the basis of a forecast and estimated figure. Companies often use their historical experience to estimate the percentage of sales they expect to become bad debt.
Recording of bad debts
When recording estimated bad debts, a debit entry is made on bad debts and an offset credit entry is made on a counter-asset account, commonly called allowance for bad debts. The allowance for doubtful accounts is deducted from the total accounts receivable presented in the balance sheet to reflect only the amount estimated to be recovered. This provision accumulates from one accounting period to another and can be adjusted according to the account balance.
Methods of estimating bad debts
There are two main methods for estimating the dollar amount of accounts receivable that should not be collected. Bad debt expenses can be estimated using statistical models such as the probability of default to determine expected losses from an overdue and past due business. Statistical calculations use historical data from the business as well as the industry as a whole. The specific percentage will generally increase as the age of the debt increases, to reflect the increased risk of default and the decrease in collectability. Alternatively, a charge for bad debts can be estimated by taking a percentage of net sales, based on the company’s historical experience in bad debts. Companies regularly make changes to the allowance for doubtful accounts, so that they correspond to the current provisions for statistical modeling.
Method of aging customer accounts
The aging method groups all unpaid accounts receivable by age and specific percentages are applied to each group. The total of all groups’ results is the estimated uncollectible amount.
For example, a business has $ 70,000 in accounts receivable under 30 days past due and $ 30,000 in accounts receivable over 30 days past due. Based on past experience, 1% of accounts receivable less than 30 days will not be collectible and 4% of accounts receivable less than 30 days will be uncollectible.
Consequently, the company will declare a provision and an expense for bad debts of $ 1,900 (($ 70,000 * 1%) + ($ 30,000 * 4%)). If the next accounting period results in an estimated provision of $ 2,500 based on unpaid accounts receivable, only $ 600 ($ 2,500 – $ 1,900) will constitute the bad debt expense for the second period.
Percentage of sales method
The sales method applies a fixed percentage to the total sales amount for the period. For example, based on previous experience, a business can expect that 3% of net sales will not be collectable. If the total net sales for the period is $ 100,000, the company establishes a provision for doubtful accounts of $ 3,000 while simultaneously declaring $ 3,000 in bad debts. If the following accounting period results in net sales of $ 80,000, an additional amount of $ 2,400 is recorded in the allowance for doubtful accounts and $ 2,400 is recorded in the second period as expenses for bad debts. The overall balance of the allowance for doubtful accounts after these two periods is $ 5,400.
The Internal Revenue Service (IRS) allows businesses to write off bad debts on Form 1040, Schedule C, if they have already been reported as income. Bad debts can include loans to customers and suppliers, credit sales to customers, and business loan guarantees. However, deductible bad debts generally do not include unpaid rents, wages or fees.
For example, a food distributor who delivers a food shipment to a restaurant in December on credit will record the sale as income on his tax return for that year. But if the restaurant closes in January and does not pay the bill, the food distributor can write off the unpaid bill as a bad debt on their tax return the following year.
Individuals can also deduct a bad debt from their taxable income if they have already included the amount in their income or lent money and can prove that they intended to make a loan at the time of the transaction and not a donation. The IRS classifies non-business bad debts as short-term capital losses.